APPLICATION OF VALUATION-BY-COMPONENTS TO RISK MEASUREMENT
AND FOREIGN EXCHANGE EXPOSURES IN INTERNATIONAL PROJECTS
by
Yoshitaka Inoue
B.S., Architectural Engineering
Tokyo University, Japan
(1979)
Submitted to the Department of
Civil Engineering in Partial Fulfillment of
the Requirements for the
Degree of
MASTER OF SCIENCE
in Civil Engineering
at the
Massachusetts Institute of Technology
January, 1990
Yoshitaka Inoue
1990
The author hereby grants to MIT permission to reproduce and to
distribute copies of this thesis document in whole or in part.
Signature of Author
J
Department of Civil Engineering
January, 1990
Certified by
Professor James L. Paddock
Thesis Supervisor
Accepted by
Ole S. Madsen
Chairman, Department Committee on Graduate Students
PAGE 2
APPLICATION OF VALUATION-BY-COMPONENTS TO RISK MEASUREMENT
AND FOREIGN EXCHANGE EXPOSURES IN INTERNATIONAL PROJECTS
by
Yoshitaka Inoue
Submitted to the Department of Civil Engineering
in January, 1990 in partial fulfillment of the requirements
for the Degree of Master of Science in Civil Engineering
ABSTRACT
Increasing demand for appropriate evaluation
methodologies for international investments is currently
recognized in order to vitalize world economies by mobilizing
capital across borders. However, the demand has not
necessarily been met by conventional or widely-used
evaluation methodologies due to complicated structures of and
risks inherent to international investments.
The purpose of this thesis is to discuss and examine the
practical applicability of " Valuation-by-Components " with
underlying theories and concepts to evaluation of
international investments, in the context of the construction
and real estate industries.
A main research issue is to test practical applicability
of two international asset pricing models, Zero-Beta Capital
Asset Pricing Model and Consumption Capital Asset Pricing
Model, to measurement of operational risks in international
setting of the construction and real estate industries.
At first, a result of the research indicates that ZCAPM
is more applicable to pricing international assets than
CCAPM, given theoretical and data-related issues on CCAPM.
The result also supports international diversification
effects of international investments which reduce systematic
risks for foreign investors as contrasted with those for
domestic investors. However, secondly, systematic and
portions of unsystematic foreign exchange risks inherent to
international investments should be hedged by using optimal
mix of operational and financial hedging instruments at
firm's level whereas firms and investors can diversify away
unsystematic foreign exchange risks to some extent. Finally,
the " Valuation-by-Components " is found to be the best
evaluation methodology among others due to its theoretical
correctness, transparency, flexibility, and outstanding
capability of analyzing and allocating relevant risks in
intelligible manners.
Thesis Supervisor:
Title:
Dr. James L. Paddock
Senior Lecturer in Civil Engineering
PAGE 3
ACKNOWLEDGEMENTS
I am deeply indebted to Professor James L. Paddock, my
thesis advisor, for his guidance and encouragement with
patience and intelligence. He opened my mind to a new
methodology of investment analysis and fundamental finance
theory through his lectures and discussions. He also
motivated me to proceed with my thesis.
My gratitude also goes to Professor Fred Moavenzadeh,
director of Center for Research and Education, and Research
Associate Charles H. Helliwell, Jr., deputy director of
Center for Research and Education, who coordinated excellent
course programs and made my study at MIT fruitful.I also
thank Professor Shyam Sunder, my academic advisor, for his
kind and valuable advice on my study at MIT.
I would like to thank President of Taisei Corporation,
Yasuo Satomi, Vice-President of Taisei, Toshiharu Yokouchi,
General Manager of Taisei, Koji Okumura and other many people
in Taisei for financially and mentally supporting me to study
I also would like to thank President of North
at MIT.
America Taisei Corporation, Yoshiya Kumazawa, and VicePresident of North America Taisei Corporation, Toshimitsu
Iimura, and other people in North America Taisei for giving
me kind supports and advices.
Throughout my stay at MIT, many friends stimulated me
and made my stay at MIT fruitful and comfortable. Among them
are Fumio Sugimoto, Koji Ikkatai, Masahiro Iwano, and
Takaharu Yamamura who gave me valuable insights on the
construction industry.
I thank my parents in Japan for their moral support.
Last but not least, I especially thank my wife, Yuki Inoue,
who has always encouraged and supported me during my stay in
the United States.
PAGE 4
TABLE OF CONTENTS
TITLE .. ...............
.....
...........................
1
ABSTRACT ..............................................
2
ACKNOWLEDGEMENTS ......................................
3
TABLE OF CONTENTS ..................................................
4
LIST OF FIGURES ........................................
9
LIST OF TABLES ........................................
CHAPTER 1:
1.
2.
INTRODUCTION ...............................
PURPOSE OF THESIS AND RESEARCH ISSUE
16
PURPOSE OF THESIS ...........................
16
1.2.
RESEARCH ISSUE ..............................
17
STRUCTURE OF THESIS ................................
19
EVALUATION METHODOLOGIES OF INTERNATIONAL
......................
22
INTRODUCTION .......................................
23
1.1.
INTERNAL RATE OF RETURN .......................
24
1.2.
NET PRESENT VALUE / ADJUSTED NET PRESENT VALUE
CONSTRUCTION PROJECTS
2.
15
1.1.
CHAPTER 2:
1.
................
10
WITH WEIGHTED AVERAGE COSTS OF CAPITAL .......
28
1.3.
VALUATION BY COMPONENTS ......................
32
1.4.
REAL OPTION APPROACH .........................
39
1.5.
COMPARISON OF METHODOLOGIES ...................
44
THEORETICAL BASIS FOR VALUATION BY COMPONENTS
2.1.
......
INVESTORS' PORTFOLIO SELECTION AND
IS .. .. ........ ........
S S EMA IC RTSKS....................
SYSTPMATTC
46
PAGE 5
2.2.
ESTIMATE OF RISK PREMIUM BY CAPITAL ASSET
PRICING MODEL
2.3.
...............................
ESTIMATE OF DISCOUNT RATES OF CONTRACTUAL AND
NON-CONTRACTUAL CASH FLOWS
2.4.
...................
3.
BASIC EVALUATION MODEL
TECHNICAL ISSUES
3.1.
51
FOREIGN CURRENCY TRANSLATION UNDER PURCHASING POWER
PARITY AND INTERNATIONAL FISHER EFFECT
2.5.
47
......
.......................
..
IN USING VALUATION BY COMPONENTS
54
57
62
MEASUREMENT OF RISKS OF NON-CONTRACTUAL CASH FLOWS
BY USING CAPITAL ASSET PRICING MODEL IN
.......................
62
...
64
.................................
66
.......................................
67
INTERNATIONAL SETTING
3.2.
CHAPTER 3:
TRANSLATION OF MULTIPLE FOREIGN CURRENCIES
MEASUREMENT OF RISKS OF NON-CONTRACTUAL
CASH FLOWS
0.
INTRODUCTION
1.
THEORY OF CAPITAL ASSET PRICING MODEL
IN INTERNATIONAL SETTING
1.1.
........................
ZERO-BETA CAPITAL ASSET PRICING MODEL
UNDER VALIDITY OF PURCHASING POWER PARITY ...
1.2.
68
CONSUMPTION-BASED CAPITAL ASSET PRICING MODEL
UNDER INVALIDITY OF PURCHASING POWER PARITY .
2.
68
74
PRAGMATIC APPLICATION OF
ZERO BETA CAPM AND CONSUMPTION-BASED CAPM ..........
2.1. CALCULATING ZCAPM & CCAPM BETAS WITH
APPROXIMATING REAL DATA TO
.....................
THEORETICAL VARIABLES...............
HEORE ICAL VARIABLES
78
PAGE 6
2.2. ESTMATING ZCAPM & CCAPM SECURITY MARKET LINE
WITH ORDINARY LEAST SQUARE REGRESSION .......
3.
RESULTS OF REGRESSION OF ZCAPM AND CCAPM ............
86
89
3.1. COMPARISON OF OBTAINED ZCAPM
WITH ZCAPM BY FAMA, MACBETH, AND SAKAKIBARA .
89
3.2. COMPARISON OF OBTAINED TWO CCAPM
(BREEDEN-TYPE AND STULZ-TYPE) ................
4.
99
MEASUREMENT OF UNLEVERED BETAS OF CONSTRUCTION INDUSTRY
AND REAL ESTATE INDUSTRY OF THE UNITED STATES AND
JAPAN ............................................. 111
4.1.
UNLEVERED BETAS OF U.S. CONSTRUCTION AND
REAL ESTATE INDUSTRY FROM U.S. AND JAPAN'S
INVESTORS' VIEWPOINTS .......................
4.2.
113
UNLEVERED BETAS OF JAPAN'S CONSTRUCTION AND
REAL ESTATE INDUSTRY FROM U.S. AND JAPAN'S
INVESTOR'S VIEWPOINTS
5.
.......................
116
ESTIMATE OF DISCOUNT RATES FOR CASH FLOWS GENERATED
BY CONSTRUCTION AND REAL ESTATE INDUSTRY OF U.S.
AND JAPAN ........................................
5.1.
121
DISCOUNT RATES OF U.S. CONSTRUCTION AND
REAL ESTATE INDUSTRY FROM U.S. AND
JAPAN'S INVESTOR'S VIEWPOINTS
5.2.
................ 123
DISCOUNT RATES OF JAPAN'S CONSTRUCTION AND
REAL ESTATE INDUSTRY FROM U.S. AND
JAPAN'S INVESTORS' VIEWPOINT ................
6.
126
EVALUATION OF SAMPLE PROJECT BY USING
OBTAINED DISCOUNT RATES ...........................
130
PAGE 7
7.
CONCLUSIONS ........................................
134
.......
137
0.
INTRODUCTION .......................................
138
1.
REVIEW FOR FOREIGN EXCHANGE EXPOSURE
...............
141
CHAPTER 4:
1.1.
EVALUATING FOREIGN EXCHANGE EXPOSURE
FOREIGN EXCHANGE EXPOSURE ON CONTRACTUAL
CASH FLOWS ..................................
1.2.
FOREIGN EXCHANGE EXPOSURE ON NON-CONTRACTUAL
CASH FLOWS ..................................
2.
3.
141
147
152
REVIEW FOR HEDGING FOREIGN EXCHANGE EXPOSURES ......
2.1.
OPERATIONAL HEDGING .........................
153
2.2.
FINANCIAL HEDGING ...........................
158
2.3.
CONCLUSION ..................................
164
VC FORMULA INCORPORATING FOREIGN EXCHANGE EXPOSURE
. 166
166
3.1.
GENERAL FORMULA OF V.C. METHODOLOGY .........
3.2.
AFTER-FX-HEDGING-ADJUSTED CASH FLOW MATRIX .. 169
CHAPTER 5:
CASE STUDY ON INTERNATIOMAL REAL ESTATE
DEVELOPMENT
PROJECT
.................
177
0.
INTRODUCTION ..................................
178
1.
PROJECT ORGANIZATION STRUCTURE AND
IN THE UNITED STATES
ORIGINAL ASSESSMENT OF THE CASE PROJECT
1.1.
......
.....
180
PROJECT ORGANIZATION STRUCTURE: MANAGING PARTNER,
CAPITAL PARTNER, AND LOCAL GOVERNMENT .. .....
180
.....
180
1.1.2 GENERAL PARTNERSHIP ............... .....
182
1.1.1 BRIEF HISTORY OF CASE PROJECT .....
PAGE 8
REDEVELOPMENT AGENCY
...................
183
I
CAPITAL PARTNER'S OVERALL
BUSINESS POSITION
1.2.
.....................
185
EXAMINING ADEQUACIES OF ORIGINAL ASSESSMENT OF
.....
CASE PROJECT
1.2.1 ORIGINAL ANALYSIS AND RESULT ...........
187
187
1.2.2 ERRORS IN GENERAL ASSUMPTION AND EVALUATION
METHODOLOGY ...........................
189
1.2.3 CONCLUSION ............................. 193
2.
V.C. APPLICATION TO CASE PROJECT ...................
194
2.1.
194
GENERAL ASSUMPTIONS
..........................
2.1.1 EQUITY CONTRIBUTION & SPLIT, AND DISTRIBUTIOIN
OF ACCOUNTING LOSS AND PROFIT .........
195
2.1.2 FINANCING ..............................
196
2.1.3 FOREIGN EXCHANGE EXPOSURE AND
FOREIGN EXCHANGE RATE .................
197
2.1.4 INFLATION RATE AND
............
203
2.1.5 OPERATION ..............................
206
PROPERTY APPRECIATION RATE
2.1.6 DEPRECIATION AND
AMORTIZATION SCHEDULE ................. 206
2.1.7 INCOME TAX AND CAPITAL GAIN TAX ........
208
2.1.8 CASH FLOW COMPONENTS AND
DISCOUNT RATE .........................
208
2.2.
V.C. OF BASE CASE ............................
210
2.3.
V.C. OF REAL CASE ............................
215
2.3.1 V.C. FOR U.S. MANAGING PARTNER .........
222
PAGE 9
2.3.2 V.C. FOR JAPANESE CAPITAL PARTNER ......
2.4.
SPECIFIC ISSUES
225
.............................. 229
2.4.1 SENSITIVITY TO GROWTH RATE OF
HOTEL ROOM RATE AND OFFICE RENT .......
230
2.4.2 SENSITIVITY TO OCCUPANCY RATE OF HOTEL AND
OFFICE ................................
233
2.4.3 SENSITIVITY TO FORECAST OF YEN-DOLLAR
EXCHANGE RATE .........................
234
2.4.4 SENSITIVITY TO MODIFIED DEPRECIATION SCHEDULE
IN MACRS IN 1986 ....................... 236
2.4.5 CONCESSIONARY SALES PRICE OF THE SITE AND
ADVANCES FOR THE ACQUISITION COSTS .... 237
2.4.6 FINANCING WITH LONG-TERM DEBT VERSUS
REVOLVING LINE OF CREDIT ............... 239
2.4.7 OPTIMAL COMPENSATION SCHEME
3.
............
CONCLUSION ........................................
242
245
CHAPTER 6: CONCLUSIONS AND RECOMMENDATIONS .............. 247
1. PRACTICAL APPLICABILITIES OF ZCAPM AND CCAPM
WITH RELATED ISSUES .............................. 249
2. IMPLICATIONS OF ZCAPM AND CCAPM BETAS AND
REAL DISCOUNT RATES ............................... 251
3. EFFECTS AND HEDGING OF FOREIGN EXCHANGE EXPOSURES ... 252
4. INTERNATIONAL FINANCING AND DIVERSIFICATION .........
255
5. ADVANTAGES OF VALUATION-BY-COMPONENTS ...............
256
PAGE 10
BIBLIOGRAPHY .......
APPENDIX .....
................................... 258
................
.......................... 265
PAGE 11
LIST
Figure
OF
FIGURES
: Comparison of Original CAPM and ZCAPM
91
Figure
ZCAPM for U.S.
Figure
Adjusted ZCAPM for U.S.
93
Figure
ZCAPM for Japan .......
92
Figure
Breeden-CCAPM for U.S.
102
Figure
Adjusted Breeden-CCAPM for U.S.
106
Figure
Breeden-CCAPM for Japan
103
Figure
Stulz-CCAPM for U.S.
104
Figure
Adjusted Stulz-CCAPM fo r U.S.
Figure
Stulz-CCAPM for Japan .. . . .
Figure
........
.. .rU.S....
107
...
.. .. . .
105
8 : Estimating Equilibrium Nominal
Exchange Rates
(Yen/S) Based on IFE
.......
201
PAGE 12
LIST OF TABLES
Table
1 : Leveraged ZCAPM Betas and Realized
Real Return
of the Selected U.S. & Japan's Firms
95
.........................
Table
2 : Comparison of ZCAPM's
Table
3 : Leveraged Breeden-CCAPM Betas and
Realized Real Return of the Selected Firms ..
Table
90
........
100
4 : Leveraged Stulz-CCAPM Betas and
Realized Real Return of the Selected Firms ..
..........
101
Table
5 : Unleveraged Betas of U.S. C&E Firms
Table
6 : Unleveraged Betas of U.S. Real Estate Firms .. 115
Table
7 : Unleveraged Betas of Japan's C&E Firms
Table
8 : Unleveraged Betas of Japan's Real Estate Firms 118
Table
9 : Real Discount Rates of U.S. C&E Firms
.......
113
117
........
123
Table 10 : Real Discount Rates of U.S. Real Estate Firms
125
Table 11
: Real Discount Rates of Japan's C&E Firms
.....
127
Table 12 : Real Discount Rates of Japan's
Real Estate Firms
............................ 128
Table 13 : V.C. of Real Estate Projects
.................
Table 14
: FX Exposure of Contractual Cash Flows
Table 15
: FX Exposure of Non-Contractual Cash Flows
Table 16
: FX Risk Exposures and Hedgings ...............
........
131
147
.... 151
165
Table 17 : Net Cash Flow Forecast before Tax,
Property Resale, and Repayment of Loan Principal
after Interest and IRR ......................
188
Table 18 : Adjusted Net Cash Flow Forecast before and after
Tax-Realted Cash Flows, and IRR .............
192
PAGE 13
Table 19 : Forecast of Exchange Rate from 1986 to 2007
.. 203
..
205
Table 20
Expected Inflation Rate in Japan ..........
Table 21
Depreciation and Amortization Schedule
Table 22
Cash Flow Components and Nominal Discount Rate 210
Table 23- 1 : Base Case
(000 US$)]
Table 23- 2 : Base Case
(ACRS
[Summary of Expected Cash Flows
211
of Expec....ted.
........
[Summary of Expected Cash Flows
(000 US$)]
Table 23- 3 : Base Case
212
[Summary of Expected Cash Flows
(000 US$)]
213
Table 24 : V.C. of Base Case (0 0 U.S. Dolla r at
-F
19Q8
207
the end
214
\
Table 25- 1 : Real Case [Summary of Expected Cash Flows
(000 US$) for U.S. developer]
Table 25- 2
217
: Real Case [Summary of Expected Cash Flows
(000 US$) for U.S. developer]
218
Table 25- 3 : Real Case [Summary of Expected Cash Flows
(000 US$) for U.S. developer]
Table 26- 1 : Real Case
[Summary of Expected Cash Flows
(000 US$) for Japan 's Subsidiar y] .
Table 26- 2 : Real Case
219
220
[Summary of Expected Cash Flows
(000 US$) for Japan 's Subsidiar y] .
Table 26- 3 : Real Case [Summary of Expected Cash Flows
Flows
yl]
.
.........
(000 US$) for Japan 's Subsidiar
221
222
Table 27 : V.C. of Real Case for U.S. Manaai ng P artner
(000 U.S.
Table 28
Dollar at the end of 19 85)
: V.C. of Real Case for Japan's Capital Partner
223
PAGE 14
with Timely Tax Payment
(000 Japanese Yen at the end of 1985)
225
Table 29 : V.C. of Real Case for Japan's Capital Partner
with Delayed Tax Payment
(000 Japanese Yen at the end of 1985)
226
Table 30 : Comparison of V.C. for Capital Partner
(000 U.S. Dollar at the end of 1985) .
226
Table 31 : Original V.C. Analysis
(000 U.S. Dollar at the end of 1985) .
230
Table 32 : Sensitivity to Growth Rate
(000 U.S. Dollar at the end of 1985) .
231
Table 33 : Sensitivity to Office Occupancy Rate
(000 U.S. Dollar at the end of 1985)
.
233
(000 U.S. Dollar at the end of 1985) .
234
Table 34 : Sensitivity to Hotel Occupancy Rate
Table 35 : Sensitivity to Exchange Rate Forecast
(000 U.S. Dollar at the end of 1985) .
235
Table 36 : Sensitivity to Modified Depreciation Schedule
(000 U.S. Dollar at the end of 1985)
.
236
Table 37 : Sensitivity to Appreciation Rate of Property
(000 U.S. Dollar at the end of 1985)
239
Table 38 : Short-Term Financing
(000 U.S. Dollar at the end of 1985)
241
Table 39 : Optimal Compensation Scheme
(000 U.S. Dollar at the end of 1985)
243
CHAPTER 1:
INTRODUCTION
PAGE 16
1. PURPOSE OF THESIS AND RESEARCH ISSUE
1.1.
PURPOSE OF THESIS
International investments take important roles in the
development of the world economy in the following positive
senses:
1) the increasing mobility of capital across countries
through the international investments vitalizes the
world economy by providing the capital to those who
can not utilize their other own idle resources due to
the shortages of the capital or the technological
immaturities;
2) the ownerships of the international investments
provide opportunities of the economic and cultural
interchanges between the countries,
which, in turn,
develop the world capital market and international
investment opportunities; and
3) the investors also can benefit from the international
investments which substantially contribute to the
international diversifications of their portfolios.
However, in spite of the apparent benefits described
above, the international investments are not easy to be
evaluated because of the complicated structures of the
ownerships, financings, sourcing inputs, and competitions,
and because of the risks inherent to the international
PAGE 17
investments, such as foreign exchange risks, political risks,
and so forth.
Therefore, it is necessary to overcome those
impediments by appropriately analyzing the complicated
structures and allocating the risks in proper manners.
Hence, the increasing necessity for appropriate evaluation
methodologies for the international investments is currently
recognized.
The motivation to study the " Valuation-by-Components "
methodology is 1) due to the strong demand for evaluation
models for international investments, which are recognized to
be currently increasing and to be certain to continue to grow
in the future as long as the framework of the open economy is
maintained and promoted in the world, and 2) because of its
outstanding capabilities of evaluating international
projects, given the current economic systems and the level of
the development of the international capital markets.
The purpose of this thesis is to discuss and examine the
practical applicability of " Valuation-by-Components " to
evaluation of international investments, in the context of
the construction and real estate industries.
1.2.
RESEARCH ISSUE
In examining the practical applicability of the
" Valuation-by-Components ", the central issue boils down to
PAGE 18
the applicabilities of the international asset pricing models
which the " Valuation-by-Components" employs, given various
restrictions, such as the data availabilities which may not
satisfy the theoretical requirements.
In the thesis, two international assets pricing models,
Zero-Beta Capital Asset Pricing Model
Capital Asset Pricing Model
(ZCAPM) and Consumption
(CCAPM), will be tested by using
the best data currently available in the context of the
construction and real estate industries.
The numerical
results of the test will be compared to the theories of the
ZCAPM and CCAPM.
Although the general test of the ZCAPM and CCAPM should
be conducted by using the data of all the industries in order
to eliminate any bias which may exist in particular
industries,
the test, conducted here in the context of the
construction and real estate industries,
provides, at least,
industry-specific results, and might give a clue to further
thorough investigations of the ZCAPM and CCAPM.
PAGE 19
2.
STRUCTURE OF THESIS
The thesis consists of six chapters, including this
introductory chapter which discusses the purpose of the
thesis, the research issue, and the structure of the thesis.
The second chapter gives an overview of the evaluation
methodologies, including the " Valuation-by-Components ",
and discusses the methodological advantages and
disadvantages.
Then, the third and fourth chapters discuss
the technical issues in applying the
" Valuation-by-Components ", first, the international asset
pricing models in the third chapter, and second, the foreign
exchange exposures and hedgings in the fourth chapter. By
using the results of the chapter three and four, the fifth
chapter analyzes the real project and compares the V.C.
analysis with the original assessment report.
Finally, the
sixth chapter concludes the thesis and discusses implications
for the international investments.
The outline of the thesis
from the second chapter through the sixth chapter is as
follows.
The second chapter discusses and compares the evaluation
methodologies currently available in the context of the
international investment analyses from methodological
viewpoints.
The evaluation methodologies discussed here are
Internal Rate of Return, Net Present Value and Adjusted Net
Present Value both with Weighted Average Costs of Capital,
PAGE 20
Valuation-by-Components, and Real Option Approach.
Finally,
this chapter discusses the technical issues in the Valuationby-Components.
The third chapter, at first, discusses and tests two
international asset pricing models, those are, the ZCAPM and
CCAPM by using the stock data of U.S. and Japan's
construction and real estate industries and the consumption
data of both countries for the past three years
through 1988).
(from 1986
The regression results of the ZCAPM and CCAPM
are compared with the empirical results obtained by the
precursors based on the data for the longer periods of time,
then the practical applicabilities and relevant issues are
discussed.
After calculating betas and real discount rates
as measurements of the business risks inherent to the
industries based on the asset pricing models, the betas and
real discount rates are interpreted from the domestic and
foreign investors' perspectives, in the long-term and shortterm.
Finally, a sample project is analyzed by using the
betas and real discount rates in order to present the effects
of the international investments.
The fourth chapter reviews the effects of the foreign
exchange exposures in the international investments on the
contractual and non-contractual cash flows in nominal terms
and real terms.
Then, the operational hedgings and the
financial hedgings are briefly reviewed in relation to the
foreign exchange exposures.
Finally, the general formula of
the Valuation-by-Components is proposed, which conceptually
PAGE 21
incorporates the costs of hedging the foreign exchange
exposures by using matrices.
The fifth chapter analyzes a real case of an
international real estate redevelopment project in U.S. by
using the Valuation-by-Components.
First of all, the
original assessment report is re-examined from the
methodological viewpoints.
Secondly, in order to evaluate
the case project in more adequate and correct manners, the
case project is analyzed in terms of the risk-return tradeoffs among the project's participants by examining the V.C.
structures, and then, sensitivity analyses are implemented
for those factors seriously affecting the project value.
Consequently, the V.C. analysis discloses the crucial points
which could not be recognized by the original assessment
report.
Finally, the sixth chapter concludes the entire
discussions by focusing on the following subjects;
1) the
practical applicabilities of the ZCAPM and CCAPM, and related
data and theoretical issues, 2) the implications of the ZCAPM
and CCAPM betas and real discount rates in the context of
U.S. and Japan's construction and real estate industries,
both in short-term and in long-term, 3) the effects of the
foreign exchange exposures and hedgings in evaluation of
international investments, 4) the international financing and
diversification, and 5) the advantages of the Valuation-byComponents.
CHAPTER 2
EVALUATION METHODOLOGIES OF
INTERNATIONAL CONSTRUCTION PROJECTS
PAGE 23
1.
INTRODUCTION
This chapter discusses evaluation methodologies for
investment analysis in the context of
dimensions.
international
Some of these methodologies are broadly-applied
while others are more recently developed from modern finance
theory.
In the discussion, these methodologies are compared
with each other in terms of methodological adequacy and
theoretical correctness of evaluating international projects.
However, the discussion is not necessarily limited to
international projects, but it can be applied to domestic
projects which have similar features in their structures of
participants, financing, and cash flows with those of
international projects.
Evaluation methodologies analyzed in this chapter are 1)
IRR
(Internal Rate of Return),
2) NPV (Net Present Value) and
ANPV (Adjusted Net Present Value),
Average Costs of Capital),
3) VC
and 4) Real Option Approach.
both with WACC
( Weighted
(Valuation by Components),
Some evaluation methodologies
such as Payback Period and Average Return on Book Value are
excluded from the discussion although these are often used
methodologies1 .
This is because these methodologies may miss
theoretically certain needed criteria, for example,
evaluation of cash flows in terms of time, that is, time
1See Brealey and Myers[1988] and Weston and Copeland[1986]
for discussions on Payback Periods and Average Return on Book
Value.
PAGE 24
value of money, which is one of the most important concepts
in finance theory I .
For this reason, I explicitly excluded
them from the following discussion.
1.1.
IRR (INTERNAL RATE OF RETURN)
IRR is a profitability measure by which expected cash
flows at each period are discounted such that a summation of
the discounted cash flows equals zero.
The calculations are
done by different numerical methods to satisfy the following
equation 2
k
Ct
I --t=0
----------- = 0:
(1)
( 1 + IRR )t
where Ct denotes an expected cash flow at period t;
IRR denotes an internal rate of return; and
k denotes a last period of series of cash flows.
In other words, IRR is a rate which makes Net Present Value
to equal zero.
In this connection, IRR is exactly the same
evaluation methodology with NPV under some specific
conditions, which will be discussed later.
Investment decision by IRR is to accept a project if IRR
is higher than an opportunity cost of capital, and vice
versa.
Opportunity costs of capital are expected rates of
1See Brealey and Myers[1988] and Weston and Copeland[1986]
for discussions on time value of money.
2 See
Brealey and Myers[1988].
PAGE 25
return for projects with equivalent risks and determined in
the capital market.
Thus, calculating IRR and making
investment decision with IRR is simple.
However, major defects in IRR methodology are generally
recognized so that IRR must be used carefully so as to avoid
falling into pitfalls of the defects 1 .
Some of the defects
are as follows:
1) increases in denominators in the equation
(1) is not
necessarily accompanied by decreases in Net Present
Value of a left side of the equation
(1);
2) multiple positive real IRRs can exist if plus or
minus signs of cash flows at each period change more
than once; and
3) projects are assumed mutually exclusive when plural
IRRs are compared and ranked;
4) IRR implicitly assumes flat term structures where
short-term and long-term interest rates are not
distinguished;
5) IRR assumes that cash flows generated by the project
can be reinvested at the Internal Rate of Return.
But, the correct reinvestment rate should be the
opportunity cost of capital for projects of
equivalent risk.
1See Brealey and Myers[1988].
PAGE 26
In addition to the above defects, some crucial defects
in evaluating international projects by using IRR rule are
pointed out as follows];
1) Due to complexities of international projects in
various sources of financing, various currencies of
cash flows, different taxation systems and tax
treaties in host and home countries, project's
organizations, multiple contracts and so forth, cash
flows in international projects generally comprise
multiple cash flow components which bear different
risks.
Especially in international projects, risks
borne by different cash flow components can vary in a
wide range.
However, in spite of the wide variances
of risks of the cash flow components, IRR methodology
discounts aggregated cash flows with a single
discount rate. Therefore, investment decisions by IRR
bring ambiguous results when applied to international
projects or equivalently complex projects.
2) Because of the complicated structures of
international projects, it is generally difficult to
find an opportunity cost of capital for the riskequivalent projects in the capital markets.
In case
it is not observed in the capital markets, an
opportunity cost of capital needs to be estimated or
an opportunity cost of capital for the most
1 See
Paddock[1989].
PAGE 27
risk-equivalent projects needs to substitute for it.
In the process of estimation or approximation of an
opportunity cost of capital, a real opportunity cost
of capital which is a sole criterion for investment
decision by IRR can be easily distorted, so
investment decisions by IRR are also distorted.
3) Discount rates in international projects can
fluctuate over periods of the projects more widely
than those in domestic projects because of
uncertainties in political and economic conditions of
the host countries, imperfections in the capital
markets and so forth.
IRR cannot accommodate the
fluctuation of discount rates over time.
4) IRR cannot directly accommodate cash flows in various
foreign currencies, so that they should be translated
into a single currency.
However, IRR doesn't
explicitly explain how to translate.
In fact, the
cash flows in multiple currencies must be
translated
with foreign exchange rates estimated for each time
period, and in the process of translating multiple
currencies into one currency, effects of foreign
exchange exposures on expected cash flows should
be explicitly taken into consideration by changing
the expected cash flows.
However, since the
translation of multiple currencies and considerations
on foreign exchange exposures are not explicitly
built in IRR methodology, and since only aggregated
PAGE 28
cash flows in a single currency are visible in the
formula(1),
it is cumbersome to implement sensitivity
analysis to various scenarios of foreign exchange
movements.
1.2.
NPV (Net Present Value) and ANPV (Adjusted Net Present
Value),
both with WACC (Weighted Average Cost of
Capital)
NPV and ANPV are absolute values of a project expressed
in certain currency of certain time (generally, time of
evaluation),
and obtained by summing up discounted expected
cash flows whereas IRR is a profitability measured based on
expected cash flows.
NPV is calculated by the following
formulal:
k
Ct
NPV = - ----------t=0
---
(2)
( 1 + DR )t
where C t denotes
an expected cash flow at time t;
DR denotes a discount rate; and
k denotes the last period of series of cash flows.
Expected cash flows are after-tax basis, and projected as if
projects are financed solely with equity, which is based on
the original Modigliani and Miller's proposition that, in a
perfect capital market, capital structure does not affect
1 See
Brealey and Myers[1988].
PAGE 29
values of firms or projects.
Thus, NPV methodology is based
on the assumption that there is no imperfection in the
markets and that investment decisions are perfectly
independent from financing decisions.
However, because of existences of imperfections in the
market such as taxations, NPV is modified to ANPV in order to
explicitly accommodate side effects of financing on project
values such as tax shields on debt interest payment.
are two ways of calculating ANPV.
There
One way is to add Net
Present Value of side effects of financing decisions
(tax
shields on debt interest) to Net Present Value of the all
equity-financed project calculated according to the formula
(2) as follows:
k
ANPV =
t=0
Ct
-E---------( 1 + DR1 )t
m
+
r * D * T
---------------
t=O
( 1 + r
(3)
)t
where C t denotes an expected cash flow at time t;
r denotes a nominal rate of interest for debt;
D denotes an amount of debt;
T denotes a corporate tax rate;
DR 1 denotes a discount rate for project cash flows;
k denotes the last period of series of cash flows;
and
m denotes a maturity of debt.
The other way is to discount cash flows with risk-adjusted
discount rates such as WACC (Weighted Average Cost of
Capital) instead of discount rates which are expected rates
PAGE 30
of return observed in the capital markets for risk-equivalent
projects.
ANPV =
ANPV and WACC are computed as follows1 :
k
Ct
- --------------t=0
:
(3a)
( 1 + ADR )t
where C t denotes
a cash flow at time t;
ADR denotes a risk-adjusted discount rate
such as WACC; and
k denotes the last period of series of cash flows.
WACC = rd *
( 1-Tc ) * (D/V)
+ re * (E/V):
(4)
where rd denotes a firm's current borrowing rate;
Tc denotes a firm's marginal income tax rate;
re denotes an expected rate of return on the firm's
stocks;
D denotes market value of firm's debt;
E denotes market value of firm's equity;
V denotes market value of firm's debt plus equity.
Although there are a couple other ways of calculating riskadjusted discount rates incorporating side effects of
financing such as MM formula and Miles-Ezzell formula, WACC
is the most widely used and can represent fundamental
characteristics of most of risk-adjusted discount rates.
Investment decisions are to accept a project if NPV or
ANPV is positive, and vice versa.
And, a project with the
largest positive NPV or ANPV should be undertaken at first
among other projects with positive NPV or ANPV if there is a
budget constraint.
1See Brealey and Myers[1988].
PAGE 31
NPV or ANPV with WACC eliminates most of the defects
mentioned on IRR in the last section.
However, WACC is used
with some limitations and assumptions such as follows:
1) a risk of a project under consideration should be the
same as that of the firm because WACC is a discount
rate for cash flows generated by the firm as a whole;
2) debt is assumed to be issued in perpetuity;
3) debt capacity of the firm is assumed constant over
the project's duration; and
4) marginal income tax rate is assumed constant over the
project's duration.
Thus, applying ANPV methodology to projects bearing risks
different from the firm's average risk may result in an
incorrect investment decision.
Moreover, the assumptions 2)
is unrealistic to individual standalone projects, and the
assumption 3) & 4) are questionable for long-term projects.
In addition to these limitations and assumptions, the
following defects of ANPV when applied to evaluating
international projects should not be overlookedl:
1) different risk classes associated with multiple cash
flow components in international projects are
inconsistent with firm's average risk expressed in
WACC.
Therefore, results of ANPV with WACC are
ambiguous because it discounts aggregated cash flows
with a risk-adjusted discount rate corresponding to
1 See
Paddock[1989].
PAGE 32
firm's average risk;
2) WACC incorporates side effects of tax shields only,
although in international projects, other side
effects generated by financing decisions such as
concessionary financing and tax credit unique to the
projects are often considerable portions of side
effects of the financing;
and
3) different taxation systems in host and home countries
cannot be incorporated in WACC.
1.3. VC
(VALUATION BY COMPONENTS)1
Valuation by Components, like NPV and ANPV, is an
absolute value of projects expressed in certain currency of
certain time.
ANPV approach.
In this sense, VC is a derivative of NPV or
The major differences of VC from NPV or ANPV
are 1) that individual components of cash flows bearing
individual risk classes are separately discounted with
different discount rates adequate to the risk classes of the
corresponding cash flow components and summed up according to
the value additivity principle, and 2) that different
discount rates are estimated based on the market-determined
rates of return by using Capital Asset Pricing Model 2.
1 See
Lessard, Flood, and Paddock[1986] for detailed
explanation of VC framework.
2 See
Sharpe[1985] for a review of Capital Asset Pricing
Model.
PAGE 33
There is no unique formula for VC because grouping
various cash flow components into those bearing the same
As a general form, a
risks changes project-by-project.
formula proposed by D.Lessard is extracted as follows1:
(5)
Valuation by Components
N
Capital Outlay
T
X
i=1
So
N
Remittable After-Tax
Operating Cash Flows
(-)
i
t=l
N
T
SSOi 1 CONTt
t+1
(5a)
/
(
(I-0)/
(5b)
2)t
(l+t
3
)
(5c)
i=1
X
T
S0 i
i=l
DEP i
t=l
I Soi
i=l
SO
)
(5d)
(5e)
INT t
t=l
(1)/
(l+Zm)t
T
Si0
i=l
4
T
N
Financial Subsidies
or Penalties
CF
i=l
N
Tax Shields Due to
Normal Borrowing
/ (l±+t1 )
t=o
SSi0
N
Depreciation Tax
Shields
'
T
Contractual Operating
Flows
It
1Si
AINTi /
(1x
6 )t
t=l
Isee Lessard[19791 for more precise discussion on the VC
formula.
(5f)
PAGE 34
N
Tax Reduction or Deferral
via Interaffiliate Transfers i=1
T
0i
N
Additional Remittance via
Interaffiliate Transfers
TRti
t=1
(1 +
7
)t
(5g)
T
S0
i
i=l1
REMt
t=l1
/
(+
7 8
)t
(5h)
where N denotes a number of currencies;
T denotes the last period of series of cash flows;
S O denotes a spot exchange rate for currency i;
superscript "i" denotes currency i;
subscript "t" denotes time period;
Q denotes a effective income tax rate;
%1 to 78 denote discount rates corresponding to
risks of grouped cash flows.
Furthermore, Lessard aggregates these eight cash flow
groups into three categories based on how the risks of the
cash flows are determined as follows:
1) non-contractual cash flows, comprising of capital
outlay and remittable after-tax operating cash flows
whose risks are determined by economic and
competitive environments surrounding the operations1 ;
2) contractual flows, comprising of contractual
operating flows, depreciation tax shields, tax
shields due to normal borrowing, and financial
subsidies or penalties whose risks are determined in
nominal terms by contracts or quasi-contracts; and
3) operating flows deliberately manipulated by the firm
1 See
Lessard , Flood, and Paddock[1986] for definitions of
contractual and non-contractual cash flows, and discussions
on risks associated with each type of cash flows.
PAGE 35
to maximize the firm's total value, comprising of tax
reduction, tax deferral, and additional remittance
via interaffiliate transfers whose risks are
determined by firm's and project's overall tax and
cash positions.
The discount rates for non-contractual cash flows which
are generally a major portion of the total cash flows are
estimated by using the market-determined expected rates of
return with Capital Asset Pricing Model whereas those of the
contractual cash flows and operating flows manipulated by
firms are estimated by using the market-determined nominal
rate of interest plus the corresponding risk premium with
Capital Asset Pricing Modell
The following formula is to compute a discount rate for
non-contractual cash flows
(remittable after-tax operating
cash flows) expressed in nominal terms:
Discount Rate =(
where
1+Rr )*( l+i )*( 1+BAE*RP ):
Rr denotes a real interest rate;
i denotes an inflation rate;
BAE denotes an all equity-financed beta of the
operation against investors' relevant
portfolio; and
RP denotes a general risk premium for
investors.
1 See
(6)
Lessard[1979] for more detailed discussion on
determinations of discount rates for contractual and noncontractual cash flows.
PAGE 36
Investment decision by VC is to accept a project if VC
is positive, and vice versa.
And, a project with the largest
positive VC should be undertaken at first among other
projects with positive VC if there is any budget constraint.
Although considered a derivative of NPV or ANPV, VC is
successful in overcoming the limitations and assumptions
required for NPV or ANPV which are discussed in the last
section1 .
These are:
1) VC can be applied to any type of project bearing any
sort of risks because VC estimates multiple discount
rates to match risks of individual cash flow groups;
2) VC can fully evaluate debt specifically issued for
the project with the specific debt terms, and is
independent from the firm's overall capital structure
because VC separates financial cash flows from
operational cash flows and discounts them with
individual discount rates free from the firm's
overall capital structure; and
3) VC can accommodate expected changes in tax deductible
marginal tax rates by adjusting cash flows affected
by the tax rates whereas a single WACC assumes the
tax rate constant.
All in all, VC is theoretically the most accurate
evaluation methodology among IRR, NPV, ANPV, and VC.
In
addition to the theoretical accuracy, VC methodology has the
1 See
Lessrad and Paddock[1986] for comparison of VC
methodology with ANPV with WACC.
PAGE 37
following advantages when applied to evaluation of
international projects:
1) VC can simultaneously deal with real and nominal cash
flows either by discounting real and nominal cash
flows with real and nominal discount rates or by
converting real or nominal cash flows into either of
them;
2) VC is so flexible to accommodate any complexity of
cash flow components in international projects by
separating different risk-bearing cash flow
components and by adding them back
value additivity principle.
according to the
Major elements of
complexity of cash flow components in international
projects are
multiple currencies, multiple interest
rates, multiple inflation rates, multiple exchange
rates, multiple tax systems, and so on can be
explicitly accommodated;
3) VC's transparency allows to grasp values of
individual cash flow components respectively, to
understand strength and weakness of the project under
consideration in terms of cash flow components, and
to clarify financing cash flows; and
4) VC allows to implement sensitivity analysis with ease
because of independent evaluation of the cash flow
components.
In spite of the theoretical accuracy and substantial
advantages of VC methodology, VC has not yet been known as
PAGE 38
widely as IRR, NPV, and ANPV.
One of major reasons is that
VC methodology is relatively newly introduced by D.Lessard ,
James Paddock and et al.
The other major reason is probably
because VC methodology is technically more complicated than
IRR, NPV and ANPV in the following points:
1) VC requires that users appropriately group various
cash flows into those bearing the same risk classes.
Therefore, the users must examine riskiness of each
cash flow whereas IRR,
NPV, and ANPV require
aggregated cash flows at each period only; and
2) the users must appropriately estimate multiple
discount rates corresponding to the riskiness of the
grouped cash flows, which can be a major challenge
for the users.
Estimating appropriate discount rates
in international setting sometimes requires that the
users fully understand the fundamental finance
theories and up-dated asset pricing models underlying
VC methodology.
On the other hand, IRR, NPV and ANPV
require to estimate only one discount rate.
However, it should be noted that this technical complication
substantially contributes to the theoretical accuracy and
transparency of VC methodology, which, in fact, decisionmakers want in investment analysis.
Rather, the technical
complication should be conquered by the users and decisionmakers so as to make appropriate decisions in investment,
especially in international projects whose complication may
not be thoroughly examined by the other methods.
PAGE 39
Therefore, technical understanding of VC methodology is
essential for VC to be implemented in a correct manner.
1.4.
REAL OPTION APPROACH1
An evaluation methodology discussed last is a real
option approach which is derived from a different form of the
same theoretical basis as IRR, NPV, ANPV, and VC.
The real
option approach is an application of option pricing model
developed lately in finance theory in order primarily to
evaluate financial options traded in the option markets such
as stock options, foreign exchange options, commodity
options, and so forth.
In this connection, the real option
approach is applied to those real assets which have operating
options, option-like characteristics, or growth
opportunities 2 .
Therefore, to draw option-like analogies
between financial options and real assets under consideration
is a key for the real option approach.
Instead of showing various derivative real option
approaches 3 ,
the following
"Black and Scholes Formula" to
calculate present value of call options for multiple periods
tells general procedures of computing option values 4:
1 See
Cox and Rubinstein[1989] for an overview of financial
option markets.
2 For
applications of option pricing model to managerial
fields, see Trigeorgis and Mason[1987]
3 For applications of option pricing model to valuation of
real assets, see Paddock,Seigel, and Smith[1987 and 1988],
Geltner[1986],
and Bar-Or[1984].
4 See
Brealey and Myers[1988].
PAGE 40
Present Value of Call Option = PN(dl) - EXe-rtN(d 2)
where
log(P/EX)
(7)
+ r*t + V*t/2
d =-------------------------- ;
(7a)
SQR(V*t)
log(P/EX) + r*t - V*t/2
d2 = -------------------------- ;
SQR(V*t)
(7b)
N(d) = cumulative normal probability density
function;
EX = exercise price of option;
t = time to exercise date;
P = price of stock now;
V = variance per period of rate of return on the
stock; and
r = risk-free interest rate.
As indicated above, calculating option values with the
formula(7) is simpler than that of IRR, NPV or ANPV, and much
simpler than that of VC because expected cash flows are not
needed to be forecast, nor discount rates.
As only five
parameters are necessary to compute the option values, the
real option approaches require very small number of
parameters to calculate the real option values although some
modifications of the formula are required.
As an example of
the application of the real option model, J.Paddock,
D.Seigel, and J.Smith[1988] drew analogies between stock call
options and undeveloped petroleum reserves as indicated below
and simulated the real option values.
PAGE 41
Comparison of Variables for Pricing Models of
Stock Call Options and Undeveloped Petroleum Reserves
Stock Call Option
Undeveloped
Reserves
--------------------------------------------------Current Stock Price
Current Value of Developed Reserve
Variance of Rate of Return Variance of Rate of Change of the
on the stock
Value of a Developed Reserve
Exercise Price
Development Cost
Time to Expiration
Relinquishment Requirement
Riskless Rate of Interest
Riskless Rate of Interest
Dividend
Net Production Reserve less
Depletion
The real option model is also
applicable to investment
projects because most of them have operating options and
option-like natures.
Although the applications of option
pricing model to various real assets, such as oil reserve
tracts, real estate investment, research & development
investment and etc.,
have been tried only for the past 10
years, and is still at development stages, the real option
approach has indicated outstanding features compared to other
evaluation methodologies such as:
1) the real option approach does not require to forecast
either future cash flows or risk-adjusted discount
rates whereas IRR, NPV, ANPV and VC requires either
or both of them;
2) the real option approach fully reflects market
valuations where assets are traded liquidly so that
it eliminates artificial errors generated in the
process of forecast or
estimation;
3) the real option model implicitly incorporates values
PAGE 42
of operating options, option-like characteristics, or
growth opportunities whereas the other methodologies
cannot include them unless they are explicitly added;
and
4) the real option approach requires substantially small
number of parameters.
The most important message that the real option models
gives to those users of the other evaluation methodologies
such as IRR, NPV, ANPV, and VC is that the other evaluation
methodologies cannot implicitly evaluate operating options,
option-like characteristics, and growth opportunities whereas
the real option approach can.
The message is a warning that
option values should be reflected in evaluation, if anyl.
Fortunately, it is possible to add the values of the options
to the other methodologies although adding the values further
complicates the calculations of the other methodologies.
However, there are some conditions that restrict
applications of the real option approaches to real assets
such as:
1) real assets should be traded in liquid markets so
that the market valuations, which the real option
approach relies on, reflect all information available
on the real assets;
2) variance of the changes in market values of the real
1 See
Myers[1984] for discussions on importance of option
values to bridge between finance theory and strategic
planning.
PAGE 43
assets should be estimated by observing the markets;
and
3) time lag of exercising financial options and real
options should be taken into considerations.
In addition to these conditions which limit applications
of the real option approach, the real option approach is
difficult to be applied to international projects.
Major
reasons are:
1) complexity of international projects disturbs
establishing option-structures which explicitly or
implicitly exists in the projects;
2) some types of international projects, such as
international construction projects, are not traded
in such a liquid market as stocks or commodities are
traded;
3) most of international projects are individually
unique so that it is difficult to observe or estimate
the market values and the variances of the specific
international projects under consideration; and
4) multiple currencies, interest rates, inflations and
etc. cannot be explicitly incorporated.
In conclusion, the real option approach is attractive due to
its simplicity and implicit inclusion of option values, but
is not easy to be applied to evaluation of international
projects.
PAGE 44
1.5.
COMPARISON OF METHODOLOGIES
As was discussed in the last sections, Valuation by
Components has methodologically superior characteristics to
the other generic methodologies such as IRR, NPV, and ANPV in
almost of all aspects except for that VC is more complicated
than the others.
Although simplicities of the other
methodologies are attractive, they are not crucial enough to
deny the superiority of VC.
VC is the most adequate
methodology for evaluation of international projects among
IRR, NPV, ANPV, and VC.
When compared with VC methodology, the real option
approach is superior to VC 1) in that the real option
approach implicitly evaluates option values of the projects,
and 2) in that less artificial errors are made by the real
option approach than VC because the real option approach
almost fully relies on the market valuations of the real
assets.
However, this is not necessarily true with regard to
evaluating international projects.
Two reasons are
identified:
1) no efficient and integrated international market,
where international projects or the similar assets
are traded with reasonable liquidity, exists at
present.
Thus, no satisfying market and market
valuation, which the real option approach is based
on, exists; and
2) there are a few international projects whose multiple
PAGE 45
elements such as currencies, tax systems and etc. are
fully reflected in the current market valuations.
In short, the current degree of integration of international
market is too premature to apply the real option approach to
evaluation of international projects1 .
On the other hand, VC
can deal with the above issues by explicitly estimating riskadjusted discount rates for project cash flows against
investors' relevant market portfolio, which will be discussed
in the next section.
In conclusion, VC is the best evaluation methodology
among those currently available.
In next section, I will
discuss the fundamental theories underlying VC methodology in
more details and
identify the most challenging technical
issues of VC methodology.
1For discussions on a degree of integration of international
capital market, see Krugman and Obstfeld[1987].
PAGE 46
2.
THEORETICAL BASIS FOR VALUATION BY COMPONENTS
As was previously indicated in the discussion on VC,
correctly
understanding fundamental theories which underlie
VC methodology is a prerequisite for correct application of
VC methodology.
Major theories supporting VC methodology
are:
1) investors' portfolio selection and systematic risks;
2) CAPM (Capital Asset Pricing Model);
3) PPP
(Purchasing Power Parity) and IFE
(International
Fisher Effect).
This section discusses above-mentioned three theories and
basic VC model, including distinctions between contractual
and non- contractual cash flows.
2.1.
INVESTORS' PORTFOLIO SELECTIONS AND SYSTEMATIC RISKS 1
A theory that investors' portfolio selections are
irrelevant to firms' activities
(firms' portfolio selections)
tells us "from which perspective and what kind of risks of
projects should be appraised."
The answer is that systematic
risks of the projects should be appraised from investors'
viewpoints.
1See Brealey and Myers[1988] for more detailed discussions on
relations between investors, capital market, and corporate
activities in terms of investor's consumption pattern.
PAGE 47
The theory behind this is that, according to capital
market theory, investors who own firms are assumed to
diversify away almost of all unique risks of their assets by
holding assets comprising
market portfolio.
the risk-free assets and the
Therefore, for investors, only systematic
risks matter whereas, for firms, maximizing firms'
values,that is, investors' equities, is a final objective as
investors' agents.
Based on the theory, systematic risks of project cash
flows are measured, and discount rates are estimated by CAPM.
2.2.
ESTIMATE OF RISK PREMIUM BY CAPITAL ASSET PRICING MODEL
Capital Asset Pricing Model is a theory that relates
systematic risks of assets to expected rates of return on the
assets in efficient market.
The relation is expressed in the
following equation:
E(r) = Rf + 8 * RPm :
(8)
where E(r) denotes an expected rate of return on the
asset;
Rf denotes a risk-free interest rate;
B denotes a relative measurement of systematic
risk of the asset against the market
portfolio;
RP m denotes a risk premium of the market
portfolio over the risk-free asset.
PAGE 48
In the formula(8),
B(beta) is called an observed beta in the
market, and it is financially leveraged.
The observed beta
is calculated as follows:
COV[ri,r
m
:
=------------
VAR [r
]
(9)
m
where COV denotes a covariance;
VAR denotes a variance;
r. denotes a rate of return on the asset;
rm denotes a rate of return on the market
portfolio.
The observed betas of stocks can be obtained in published
beta books.
However, betas of the formula(9) is financially
leveraged whereas all equity-financed betas are necessary to
compute risk premiums for estimation of discount rates.
relationship of leveraged betas
The
(observed betas) and all
equity-financed betas can be obtained from MM proposition.
The Modigliani and Miller's proposition that the expected
rates of return on firms' stocks increase in proportion to
the increases of the debt-equity ratios of firms can be
translated into the relationship of leveraged betas
(observed
betas) and all equity-financed betas in the following
formulal:
1 See
Brealey and Myers[1988] for the translation of the MM
proposition to the formula(10).
PAGE 49
BE =
A
+ (D/E)
* (
A
D)
-
(10)
where BE denotes a leveraged equity beta;
SA denotes an all equity-financed beta;
B D denotes an beta of debt;
D denotes a market value of debt;
E denotes a market value of equity.
By incorporating effects of tax shields on interest payment
and assuming that the debt is almost risk-free
= 0),
(beta of debt
the formula(10) is rewritten as follows:
After-tax market value of debt
=(market value of debt) (PV of tax shield on debt interest)
D * r * T
k
t= -------------( 1 + r )
( 1 +r )
t=1
D*r*T
= D - ----- *
[ 1 - ----------( 1 + r )
where T denotes an effective tax rate;
r denotes a nominal rate of interest on
debt; and
k denotes a maturity of debt.
I assume that firms continue to operate as long as
possible so that I assume maturity of debt(k) approximates to
infinite time.
Under the assumption, the term 1/(l+r)t
converges to zero.
Therefore,
PAGE 50
After-tax market value of debt
D - D * T
= D * (l-T):
(10a)
Also, I assume the debt is almost risk-free, thus
BD = 0:
(10b)
Substituting D of(10a) and BD of
(10b) for those of
(10),
BE =
A + (D*(1-T)/E) * (3A - 0)
= BA + (D/E) *
(1 - T) *
BA:
(lOc)
Therefore, rearranging (10c),
BA = BE / (1 + (1 - T) * (D/E)):
(11)
Finally, the risk premiums for all equity-financed betas are
obtained by the following formula:
RP =
=
B8
* RP
A
8E / - (1 + (1 - T)
E
* D/E)
* RP m
m
COV[ri,rm]
=
----
---------------* -----------------
VAR [r
m]
1 + (1 - T)
* RPm
:
(12)
* D/E
However, when VC is applied to international projects,
there exist major difficulties in calculating the risk
premiums according to the formula(12), because investors'
PAGE 51
relevant market portfolios and consumption patterns are not
homogeneous all over the world.
This technical difficulties
will be discussed in next section 3 TECHNICAL ISSUES IN USING
VALUATION BY COMPONENTS.
2.3.
ESTIMATE OF DISCOUNT RATES OF CONTRACTUAL AND
NON-CONTRACTUAL CASH FLOWS
As was discussed in the section 1.3. VALUATION BY
COMPONENTS, cash flow components are grouped according to how
risks of cash flow components are determined.
Lessard's general formula
Although D.
(5) groups various cash flows into
three categories in order to explicitly separate cash flows
at the disposal of the firm to take advantage of
imperfections in tax systems from others, the basic
categories of cash flow components are contractual and noncontractual cash flows.
Contractual cash flows are denominated in nominal terms
of certain currency.
Those cash flows are such as contracted
capital expenditures, contracted operating cash flows, tax
shields on depreciation/amortization, tax shields on interest
expenses, concessionary borrowings and so forth.
These cash flows are divided into two types of
contractual cash flows.
The first type is a cash outflow
according to an obligation to pay to the third party under
the contract.
The second type is a cash inflow according to
a claim to be paid by the third party under the contract.
PAGE 52
However, regardless of cash inflows or outflows, risks of
contractual cash flows are theoretically the same under the
existence of the complete capital market because firms can
create the same series of cash flows by lending or borrowing
in the complete capital market with the same interest rate.
For instance, when a firm borrows $100 million under a
balloon-payment borrowing contract which matures 10-years
later with an annual interest rate of 10%, the firm is
obliged to pay $10 million from the first year through 9th
year, and $110 million in the 10th year.
At the same time
when the firm borrows $100 million, the firm can lend the
$100 million to the third party under a lending contract
whose terms are exactly the same as those of the borrowing
contract the firm agreed with the lender, because the capital
market is complete.
Therefore, the firm has a claim to the
same series of cash flows as those of the firm's obligation.
Consequently, the firm's cash flows of simultaneous lending
and borrowing at each period and NPVs ends up with zero.
This simple sample indicates that risk of contractual cash
flows, regardless of claims or obligations, is identical with
each other under the existence of the complete capital
market.
Therefore, as an approximation, discount rates for
contractual cash flows are assumed the same as the firm's
borrowing and lending rate.
However, the firm's borrowing
rate is generally higher than the risk-free lending rate
because the borrowing rate reflects not only expectations of
PAGE 53
real rate of interest and inflation but also expectations of
the firm's default risk and covariance risk with the economy
where the firm operates.
Since the contractual cash flows
have the same risk structure, the firm's borrowing rate of
certain currency, which denominates the contracted amount, is
used as a discount rate.
In addition to the firm's borrowing rate, some sort of
risk premiums may be necessary to be added to the borrowing
rate, depending on the nature of the contractual cash flows.
The second type of cash flow, non-contractual cash
flows, is affected by the economic and competitive
environments around them.
The non-contractual cash flows are
such as non-contracted capital expenditures, non-contracted
operational cash flows, and so on.
Risks of non-contractual cash flows are divided into two
types,these are, 1) systematic risks ,
and 2) unique risks.
As was discussed in the section 2.1. INVESTORS' PORTFOLIO
SELECTION AND SYSTEMATIC RISKS, only systematic risks do
matter for investors.
Therefore, only systematic risks of
non-contractual cash flows should be taken into account.
In the last section 2.2. ESTIMATE OF RISK PREMIUMS BY
CAPITAL ASSET PRICING MODEL, risk premiums for systematic
risks of assets were shown.
By using the formula(12) of the
last section, the discount rate for non-contractual cash
flows is calculated as follows:
PAGE 54
Discount Rate
=
(l+Rf)
(1 +1+I)
* (1 + RP)
COV[ri,r
(1+R )*(1+I)*(+
(13)
m]
-----------VAR[rm]
1
*-----------------------*RPm)
1 + (1 - T) * D/E
where Rf denotes a risk-free real interest rate of home
country; and
I denotes an inflation rate in home country.
However, the formula(13) is based on the important
assumption that there must exist a risk-free interest rate,
which, in fact, cannot be observed in real world 1 .
This
issue will be discussed in next section 3 TECHNICAL ISSUES IN
USING VALUATION BY COMPONENTS.
2.4.
FOREIGN CURRENCY TRANSLATION UNDER PURCHASING POWER
PARITY AND INTERNATIONAL FISHER EFFECT
Foreign currency translation is not a fundamental part
of the theories supporting VC methodologies.
considered
Rather, it is
a part of the process of projecting incremental
future cash flows.
However, under certain conditions, VC
methodology can explicitly incorporate foreign exchange
translations in its general formula in a simple manner.
1 See
Fama and MacBeth[1983]
Lintner CAPM.
In
for empirical tests of Sharpe-
PAGE 55
fact, the VC formula(5) proposed by D.Lessard implicitly
assume the conditions, these are, Purchasing Power Parity
(PPP) and International Fisher Effect
(IFE).
PPP means that aggregated real price levels among
different countries should be the same, namely, that foreign
exchange rates should be adjusted according to the
differentials of the inflation rates among the countries so
that the aggregated real price levels are kept at the same
level.
This notation for one period is expressed in the
following formula:
Pt
/
P0
St = SO * ------------Pt
P0gi-i
0
1 + It
SO * ------------
(14)
1 + Itt
where S O denotes a spot exchange rate of home
currency against foreign currency
at time = 0;
S t denotes a spot exchange rate of home
currency against foreign currency
at time = t;
P 0 denotes price level of home country
at time = 0;
Pt denotes price level of home country
at time = t;
P0 denotes price level of foreign country
at time = 0;
Pt
It
It
denotes price level of foreign country
at time = t;
denotes an inflation rate of home country
from time = 0 to time = t; and
denotes an inflation rate of foreign
country from time = o to time = t.
PAGE 56
The formula(14) is generalized for multiple periods as
follows:
St
(1 + I1)*(l + I2)*-------- *(
+ It )
= SO*-----------------------------------(1
I
)*(1 + 12------- *(1
(14a)
+ It )
Unfortunately, PPP is generally recognized not to always
hold, but to hold on average or in the long-run.
IFE means that foreign exchange rates should be adjusted
according to the differentials of the nominal interest rates
among countries
(which are theoretically exactly the same as
the differentials of the inflation rates among the
This notation for one period is expressed as
countries).
follows:
1 + rt
S
S
* ------------ :
(15)
1 + rt
where
rt denotes a nominal interest rate of home
country at time = t; and
rt denotes a nominal interest rate of
foreign country at time = t.
The formula(15) is generalized for multiple periods as
follows:
(1 + rl)*(l + r2)* -------- *(
S t = SO*
+ rt)
(15a)
- - - - - - -- - - - - - - - - - - - - - - - - - - - - - - - - - - -
(1
+ r
I
)*(1 + r
2
)*-------*(1 + r t
)
PAGE 57
IEF is recognized to have a strong tendency to hold in the
long-run.
However, in the short-run, the effectiveness of
IFE is not clear, because the nominal interest rates may be
affected not only by the differentials of the inflation rates
among countries but also by the fluctuations of the real
interest rates.
This is because some literatures test IFE in
terms of the historical exchange rates as opposed to the
expected exchange rates which IFE originally meant1 .
However, as was discussed in this section, because PPP
and IEF don't strictly hold, translating foreign currencies
into home currencies is not easy task.
This issue will be
discussed in next section 3 TECHNICAL ISSUES IN USING
VALUATION BY COMPONENTS.
2.5.
BASIC EVALUATION MODEL
In this section, two basic VC evaluation models 1) a
model for contractual cash flow components discounted with
the corresponding discount rates, and 2) a model for noncontractual cash flow components discounted with the
corresponding discount rates are discussed under the
theoretical basis described in the previous four sections
with explicit assumptions.
1 For
discussions on the empirical evidence for IFE, see
Shapiro[1989], Solnik[1988], and Eiteman and Stonehill[1989].
PAGE 58
Contractual cash flows are generally fixed and
denominated in nominal terms of certain currency and
discounted with the firm's nominal borrowing rate when the
contracts are agreed upon.
Although all of the contracts are
not necessarily signed when the project starts, the
assumption (1) that all contracts are agreed at time = 0 is
made.
Therefore, the constant borrowing rates at time = 0
are used as discount rates.
Strictly speaking, the borrowing
rates should be adjusted by the risk premiums, depending on
the risks borne by the cash flows.
Here, the assumption
(2)
that the risk premiums for contractual cash flows are
constant over time is made.
Thus, a general formula of
discount rates for contractual cash flows is expressed as
follows:
Discount Rate =
where r 0
RP
(1 + r
) *
(1 + RP
):
(16)
denotes the firm's nominal borrowing
rate in currency i at time = 0; and
denotes a risk premium for corresponding
cash flows.
Translation of contractual cash flows in terms of a
foreign currency into the home currency is made by using the
exchange rate when the contract is agreed upon.
the assumption
According to
(1) above and the assumption that PPP holds,
the translation exchange rate for the contractual cash flows
is the spot exchange rate at time = 0.
PAGE 59
Therefore, a general formula to calculate VC values of
contractual cash flows expressed in terms of home currency is
as follows:
* So
S0
CF t(n)
t
N
t=O
i=l
[(I + r i)
* (1 + RP i )]t
(n)
CFt
so
Ss i I -----------------i=1
t=O
[(1 + r
i)
*
--------
(1 + RP
i
(17)
)]t
where N denotes a number of currencies;
T denotes a number of periods of cash flows;
S 0O
CFt
denotes a spot exchange rate of home
currency against foreign currency i
at time = 0; and
(n) denotes nominal cash flows in
currency i at time = t.
Non-contractual cash flows are affected by economic and
competitive conditions and generally affected by inflation
rates.
The discount rates for the non-contractual cash flows
are discussed in detail in the section 2.3. ESTIMATE OF
DISCOUNT RATES OF CONTRACTUAL AND NON-CONTRACTUAL CASH FLOWS.
The formula to calculate the discount rate is
(13):
Discount Rate
= (1+Rf)
*
(1+I) * (1 + RP)
(13)
PAGE 60
In the formula(13), the risk-free real interest rate,Rf, is
However, the
generally recognized to vary over time.
assumption(3) that the risk-free real interest rate is
constant over time, and the assumption(4) that the risk
premiums for non-contractual cash flows are constant are
made.
Therefore, a general formula to calculate VC values of
non-contractual cash flows expressed in terms of home
currency is as follows by using PPP formula(14a):
i=1
t=0 (1+Rf)t*(l
+ Il)
*
----
*
CF ti(r)*(l + Ii)
T
N
* St
CF ti(n)
T
N
(1 + It)*(l
+ RP)t
* (1 + I
*
Z Ix -----------------------------------i=1
(1+Rf)t*(l
t=0
(1 + I l
+ Il
)
)
* ----
*
* (1 + 12)
* --------
* (1 + I t )
------------------------------------
so
(1 + I
T
) *
1
(1 +
2 )* ------- * (1 + Iti)
CFti (r)
------------------------- :
Ss 0 i
i=1
*
(1 + It)*(l + RP)t
i
N
)
t=0
[(1+Rf)
*
(8)
(1 + RP)]t
where N denotes a number of currencies;
T denotes a number of periods of cash flows;
Sti denotes a spot exchange rate of home
currency against foreign currency i
at time = t;
CF t(n) denotes nominal cash flows in
PAGE 61
currency i at time = t;
CFti(r) denotes real cash flows in
currency i at time = t;
It denotes an inflation rate of home country
from time = t-1 to time = t;
It denotes an inflation rate of foreign
country ,whose currency is i,
from time = t-1 to time = t;
Rf denotes a risk-free real interest rate of
home country;
RP denotes a risk premium of cash flows, which
is calculated with the formula(12).
These two models on contractual and non-contractual
models are applied to different risk-bearing cash flows to
formulate a general formula of VC.
The total VC is obtained
simply by adding the discounted multiple components.
One
example is the formula(5) by D.Lessard.
However, as was noted in the previous sections, since
there exist theoretical and technical issues in the
underlying theories, these models cannot be used without
restrictions inherent to the supporting theories, especially
the PPP theory. Therefore, these models will be modified in
order to explicitly add foreign exchange exposure terms as
independent components in Chapter 4: FOREIGN EXCHANGE
EXPOSURE.
PAGE 62
3.
TECHNICAL ISSUES IN USING VALUATION BY COMPONENTS
This section discusses technical issues in VALUATION BY
Two
COMPONENTS which were pointed out in the last sections.
major technical difficulties are recognized in using VC
methodology : 1) how to measure risks of non-contractual cash
flows with CAPM, and 2) how to evaluate effects of foreign
exchange exposures.
3.1.
MEASUREMENT OF RISKS OF NON-CONTRACTUAL CASH FLOWS
BY USING CAPITAL ASSET PRICING MODEL IN INTERNATIONAL
SETTING
Risks of non-contractual cash flows were discussed in
the section 2.2. ESTIMATE OF RISK PREMIUM BY CAPITAL ASSET
PRICING MODEL.
According to the formula(12), all equity-
financed beta, BA,
is measured by the following formula:
COV[r i ,rm]
A
=
-----------VAR[rm]
1
* ----------------1 + (1 - T) * D/E
:
(19)
In order to compute with the formula(19), at first, a
covariance of rates of return of similar projects and
investors' relevant market portfolio must be calculated;
secondly, a variance of rate of return of investors' relevant
market portfolio must be calculated.
Calculating the
PAGE 63
covariance and variance is technically very difficult
because:
1) investors' relevant market portfolio is hardly
determined because some diversify their portfolio
internationally, others diversify their portfolio
domestically, and the others are somewhere between
the two extremes.
Therefore, investor's portfolio is
assumed to be a combination of domestic and foreign
market portfolios.
However, the weight of each
market portfolio of the entire portfolio is unknown;
2) investor's holding portfolio is related to the PPP
risks to an extent which the investor hedges the PPP
risks.
Therefore, the influences of the PPP risks on
the investor's portfolio selection must be taken into
account;
3) investor's consumption pattern also must be taken
into account because the consumption pattern affects
the investor's portfolio selection1 ; and
4) a rate of return of similar projects in a host
country is very hard to find, therefore, a covariance
of rates of return of similar projects and investors'
relevant market portfolio is hard to calculate.
In next Chapter 3. MEASUREMENT OF RISKS OF NON-CONTRACTUAL
CASH FLOWS, two extensions of Sharpe-Lintner CAPM, these are,
1) Zero-Beta CAPM and 2) Consumption-CAPM, are briefly
1See Breeden[1979] for discussions on consumption-based asset
pricing model.
PAGE 64
discussed in connection with the above issues, and all-equity
betas are calculated statistically by using the concepts of
the two derivative CAPMs.
3.2.
TRANSLATION OF MULTIPLE FOREIGN CURRENCIES
Although PPP and IFE are assumed to hold in order to
formulate basic VC models, there is historical evidence that
they don't hold in their strict senses1 . Therefore, expected
cash flows are exposed to the deviations from PPP and IFE.
It does not necessarily mean that all foreign currency cash
flows are exposed to FX risks ,but
that unmatched amounts of
each foreign currency cash flows at each time are exposed to
FX exposures.
Therefore, calculating the unmatched amounts
is essential to estimate effects of FX exposures.
This
process complicates VC or any other methodologies to a great
extent.
These foreign exchange exposures can be hedged either by
operational or by financial instruments.
The operational
hedging is more certain that the financial hedging because
the financial hedging relies on the capital market which is
not necessarily predictable with certainty.
Thus, costs of
hedging by the financial instruments are ambiguous.
If FX exposures cannot be hedged or intentionally are
not hedged, effects of FX exposures should be included in VC
1 See
Shapiro[1989] and Solnik[1988] for discussions on
empirical evidence for PPP and IFE.
PAGE 65
evaluation.
However, since foreign exchange rates behave
like a random-walker, it is very hard to generalize
evaluation of FX exposures.
Rather, it should be evaluated
project-by-project by estimating exposed amount of foreign
currencies.
In Chapter 4: FOREIGN EXCHANGE EXPOSURE --- US$
VS YEN, a simple model of foreign exchange exposures will be
presented and this component will be explicitly incorporated
into the general formula of VC analysis proposed by Lessard.
CHAPTER 3
MEASUREMENT OF RISKS OF NON-CONTRACTUAL CASH FLOWS
PAGE 67
0.
INTRODUCTION
As was discussed in the last chapter, measuring risks of
non-contractual cash flows by using Capital Asset Pricing
Models in international setting is challenging mainly due to
the difficulties 1) in identifying the investor's relevant
portfolio; 2) in discovering a degree and effects of the
integration of the world market; and 3) in examining effects
of the PPP risks and the consumption patterns on the
investor's portfolio selection.
This chapter is devoted to pragmatically measure risks
of non-contractual cash flows generated by the US and
Japanese construction and real estate industries in
international setting.
The chapter, at first, briefly
reviews two extensions of the Sharpe-Lintner CAPM, these are,
1) Zero-Beta CAPM (ZCAPM), and 2) Consumption-Based CAPM
(CCAPM) respectively, in relation to the validity or
invalidity of the Purchasing Power Parity.
Secondly, ways of
using ZCAPM and CCAPM are discussed in order to pragmatically
calculate all equity-financed betas in international setting.
Then, after estimating discount rates, a sample project is
evaluated by using the obtained discount rates.
results of the sample project and the
Finally, the
adequacy of the
pragmatic usage of the ZCAPM and CCAPM are discussed.
PAGE 68
1.
THEORY OF CAPITAL ASSET PRICING MODEL IN
INTERNATIONAL SETTING
Many studies on international asset pricing models have
been done mainly from two different views: 1) based on the
segmented country market and 2) based on the integrated world
market1 .
In this section, Zero-Beta CAPM and Consumption-Based
CAPM are briefly discussed among several international asset
pricing models because these two models can theoretically
accommodate the validity or invalidity of the PPP and because
they are relatively easy to be handled for pragmatic
application to estimating expected rates of returns in
international setting, in addition to their theoretical
clarity and superiority 2 .
Then, in next section, both ZCAPM and CCAPM are used for
their pragmatic application.
1.1.
ZERO-BETA CAPITAL ASSET PRICING MODEL
UNDER VALIDITY OF PURCHASING POWER PARITY
1For a brief review of developments on international asset
pricing models, see Copeland and Weston[1979].
For more
detailed discussions on international asset pricing model,
see Black[1974], Grauer,Litzenberger, and Stehle[1976],
Solnik[1974], Stehle[1977], and Stulz[1984].
2 See Lessard,
Flood , and Paddock[1986] for rationalization
of Zero-Beta CAPM and Consumption-Based CAPM in international
setting.
PAGE 69
The Sharpe-Lintner CAPM [formula(8) and (9)] estimates
nominal expected rates of return with a crucial assumption
that a risk-free borrowing and lending rate is available
without limitation.
For example, the Treasury Bill, which is
considered almost default-free, is not totally risk-free
because the nominal interest rate of the Treasury Bill does
not necessarily exactly cover the fluctuations of the
inflation rates over time, though it comes very close over
short periods.
The Zero-Beta CAPM was introduced by Black in 1972 so as
to eliminate the restriction imposed on the Sharpe-Lintner
CAPM that a risk-free lending and borrowing rate must exist1 .
By mixing a minimum-variance zero-beta portfolio with the
market portfolio with adequate ratios, the Zero-Beta CAPM
claims that expected rates of return on risky assets have
proportional relations with the standard deviations of the
rates of return on the risky assets, which is exactly the
same claim which the Sharpe-Lintner CAPM made, except that
the risk-free rate of interest is replaced by the rate of
return on a minimum variance zero-beta portfolio .
The
Zero-Beta CAPM is expressed by the following formula 2:
E(Ri) = E(Rz) + [E(Rm) - E(Rz)] * Bi:
(20)
where E(Ri) denotes an expected real rate of return
on a risky asset i;
E(Rz) denotes an expected real rate of return
on a minimum variance zero-beta
1 See
2 See
Black[1972].
Copeland and Weston[1979].
PAGE 70
portfolio;
E(Rm) denotes an expected real rate of return
on the market portfolio; and
8i denotes a beta of the risky asset i over
the market portfolio, and given by the
following formula:
8i = COV[Ri,Rm] / VAR[Rm]
(20a)
An important finding of the Zero-Beta CAPM is that the
Security Market Line would be flatter than defined by the
Sharpe-Lintner CAPM, therefore, risky assets whose betas are
less than 1(one) require higher expected rates of return than
the Sharpe-Lintner CAPM estimates and risky assets whose
betas are more than 1(one) require lower expected rates of
return than the Sharpe-Lintner CAPM estimates.
This finding
is known to correspond to the empirical tests1 , which is
shown in
Figure 1: Comparison of Original CAPM and ZCAPM.
As the figure indicates, the empirical rate of return on the
zero-beta portfolio is substantially higher than those on the
treasury bills, and the SML is flatter than that of the
Sharpe-Lintner CAPM.
This is because the Zero-Beta CAPM
assumes investors to hold minimum variance zero-beta
portfolios whose rates of return are higher than those of
almost risk-free assets.
Thus, when the PPP holds, Zero-Beta CAPM is used for
international asset pricing with the following assumptions:
1) the Purchasing Power Parity holds;
2) the world capital market is perfect,complete, and
1See Fama and MacBeth[1973] for the results of empirical
tests.
PAGE 71
integrated;
3) investors are risk-averse, and no satiation;
4) no asymmetry of information;
5) all investors' consumption baskets of goods are
identical all over the world; and
6) real prices of the consumption basket are the same
all over the world due to the validity of the PPP.
As a result, the Zero-Beta CAPM in the international setting
claims that discount rates in real terms are the same all
over the world.
Therefore, investors in different countries are indifferent
to the same international project because the value of the
project is unchanged from any investor's viewpoint.
PAGE 72
0.03
0.03
0.02
0.02
0.01
0.01
0.00
0
0.00
1
2
3
BETA
---
ORIGINAL CAPM
ZCAPM (%)
Source
Figure
: Fama and Macbeth
1:
Comparison
of
[1973]
Original
CAPM
and
ZCAPM
PAGE 73
However, since the above assumptions 1),
2),
5),
and 6)
are not generally recognized to be realistic, applying the
ZCAPM to calculating discount rates is sometimes unrealistic.
Besides the restrictive assumptions, there is a fundamental
difficulty in pragmatically applying the ZCAPM in the
international setting.
That is, how to obtain the world
market portfolio which everyone in the world is assumed to
hold.
Although we can obtain an index close to the world
market portfolio, such as those issued by the Morgan Stanley
Capital International Perspective, the index may not be
appropriate because the index is always affected by the
fluctuations of the foreign exchange rates and different
inflation rates among the countries.
Consequently, the index
is dependent on which currency is used as a base currency
unit.
There is the other way to apply the ZCAPM, which is not
based on the above mentioned assumptions, but based on the
assumptions which replace the previous assumption 2) with the
following new assumption 2):
2) the segmented capital market is perfect and complete,
whereas the world capital market is not necessarily
SO.
Advantages of the modified assumptions is 1) that data of the
segmented market portfolio is easy to be obtained and free
from the effects of the foreign exchange conversions and
different inflation rates conversions, and 2) that an
assumption that those in each segmented market hold the
PAGE 74
market portfolio in the corresponding segmented market is
likely to reflect more reality than the assumption that that
everyone in the world holds the identical world market
portfolio, given the current degree of the integration of the
world market.
On the other hand, it is generally recognized
that this new assumption tends to underestimate risks of
international assets, because it is true that the investors
currently, more or less, diversify their portfolios
internationally so that their asset holdings are not limited
to those in the corresponding segmented markets.
In this thesis, I will apply the ZCAPM under the
modified assumptions because of the advantages mentioned
above, recognizing that it may overestimate the risks of the
international assets.
In later section, a way of pragmatically using the Zero
Beta CAPM will be discussed.
1.2.
CONSUMPTION-BASED CAPITAL ASSET PRICING MODEL
UNDER INVALIDITY OF PURCHASING POWER PARITY
When the PPP does not hold, investors in different
countries are exposed to risks of different inflations and
fluctuating foreign exchange rates.
Since risk-averse
investors try to hedge against those risks by holding
country-specific hedge portfolios in order to stabilize their
consumptions, real rates of return on risky international
PAGE 75
assets from different countries' investors' perspectives are
also country-specific.
Under the framework of the Consumption-Based CAPM,
investors in a country hold portfolios comprising three
different portfolios. These arel:
1) safety portfolios which are uncorrelated with
investors' real consumptions;
2) well-diversified portfolios which are "the tangency
portfolios on the efficient frontiers for each
country; and
3) hedge portfolios which offset unexpected changes in
investors' costs of living.
The general formula of the Consumption-Based CAPM is
given by the following 2:
E(Ri) = E(Rzc) + [E(Rp) - E(Rzc)] * Bic:
(21)
where E(Ri) denotes an expected real rate of return
on a risky asset i;
E(Rzc) denotes an expected real rate of return
on a portfolio uncorrelated with real
consumption;
E(Rp) denotes an expected real rate of return
on an arbitrary portfolio; and
Bic denotes a beta of the risky asset i
determined by investor's real consumption
and reference portfolio, and given by the
following formula:
Bic = COV[Ri,Cl] / COV[Rp,C 1 ]
(21a)
1See Stulz[1984] and Lessard,Flood, and Paddock[1986] for
more detailed discussions on the component portfolios of the
entire portfolio under the framework of the Consumption-Based
CAPM.
2 See Breeden[1979]
and Stulz[1984] for the derivation of the
formula.
PAGE 76
where Cl denotes a real consumption
of a representative
domestic investor.
Thus, when the PPP does not hold, the Consumption-Based
CAPM is used with the following assumptions:
1) the Purchasing Power Parity does not hold;
2) the segmented capital market is perfect and complete,
whereas the world capital market is not necessarily
so;
3) investors are risk-averse, and no satiation;
4) no asymmetry of information;
5) investors' consumption baskets are identical within
each country, but different from country to country;
and
6) real prices of the consumption baskets are different
from country to country due to the invalidity of the
PPP.
As a result, the Consumption-Based CAPM claims that discount
rates in real terms vary country-by-country.
Therefore, the
value of the identical international project varies,
depending on where the investors live.
mentioned
Although the above-
assumptions are required for the use of the
Consumption-Based CAPM, the Consumption-Based CAPM can
theoretically accommodate the issues discussed in section
3.1. of Chapter 2, within its framework.
However, it should be noted that there are two different
ways of calculating the CCAPM betas proposed by two
PAGE 77
respectable precursors, D.Breeden [1979] and R.Stulz [1984].
Breeden, who originally proposed the CCAPM, claims that CCAPM
betas are calculated as a ratio of covariance of return on
risky assets with changes in consumption to covariance of
return on arbitrary safety portfolio with changes in
consumption, whereas Stulz claims that CCAPM betas are
calculated as a ratio of covariance of return on risky assets
with level of consumption to covariance of return on
arbitrary safety portfolio with level of consumption.
In this thesis, I will apply both calculation methods by
Breeden and Stulz because it is worthwhile to apply both
methods.
This is simply because the second article(Stulz)
does not clarify why he uses the level of consumption rather
than the changes as Breeden originally used.
Thus, there are
these two methods of calculating the CCAPM betas and because
theoretical models like the CAPM must be statistically tested
so that the conformity and applicability of the model with
the reality should be verified.
In next section, a way of pragmatically using the
Consumption-Based CAPM will be discussed.
PAGE 78
2.
PRAGMATIC APPLICATION OF
ZERO BETA CAPM AND CONSUMPTION-BASED CAPM
In this section, how to apply the Zero Beta CAPM and
Consumption-Based CAPM for the purpose of calculating betas
and estimating the respective Security Market Line is
discussed.
Appropriate approximation and additional
assumptions are required to pragmatically use the ZCAPM and
CCAPM due to limitations on real data available and
difficulties in identifying the theoretical variables of the
ZCAPM and CCAPM in real world.
First, how to calculate betas is discussed, and second,
how to estimate the Security Market Line with Ordinary Least
Square Regression is discussed.
2.1. CALCULATING ZCAPM & CCAPM BETAS
WITH APPROXIMATING REAL DATA TO THEORETICAL VARIABLES
Betas of the Zero Beta CAPM and Consumption-Based CAPM
are calculated with the formula
(20a) and (21a),
respectively:
ZCAPM: Bi = COV[Ri,Rm] / VAR[Rm]
(20a)
CCAPM: Bic = COV[Ri,C1] / COV[Rp,Cl]
(21a)
Each variable on the right side of the formula is discussed
below.
PAGE 79
First o all, 10(ten)
U.S. construction and engineering
firms, 8(eight) U.S. real estate investment companies,
11(eleven) Japanese construction and engineering firms, and
4(four) Japanese real estate companies are selected as
representatives of U.S. and Japan's construction and real
estate industries so that the monthly rates of return on the
stocks of the selected firms for three years (1986-1988) are
assumed to be rates of return on risky assets in order to
calculate betas of the selected firms.
The selected firms
are as follows with the stock markets where the stocks of the
selected firms are traded in the parenthesis:
1) U.S. construction and engineering firms:
CBI Industries (NYSE)
Centex General (NYSE)
CRSS (NYSE)
Flour Daniel (NYSE)
Foster Wheeler (NYSE)
Jacobs Engineering (ASE)
Morrison Knudsen (NYSE)
Perini (ASE)
Stone & Webster (NYSE)
Turner (ASE)
2) U.S. real estate trust companies:
California REIT (NYSE)
Cenvill (NYSE)
Federal Realty (NYSE)
First Union (NYSE)
Hotel Investment (NYSE)
HRE Properties (NYSE)
IRT Properties (NYSE)
Saul B.F.RL.Inv. (NYSE)
3) Japanese construction and engineering firms:
Aoki Construction (TSE)
Fujita Corp (TSE)
Haseko (TSE)
Hazama-gumi (TSE)
Kajima (TSE)
Kumagai-gumi (TSE)
Maeda Corp (TSE)
PAGE 80
Ohbayashi Corp (TSE)
Penta Ocean Construction (TSE)
Shimizu Construction (TSE)
Taisei Corp (TSE)
4) Japanese real estate development companies:
Daikyo (TSE)
Mitsubishi Estate (TSE)
Mitsui Real Estate (TSE)
Sumitomo Realty and Development (TSE)
The formula of calculating pre-tax monthly real rates of
return on the stocks of the selected firms and the sources of
the data are as follows1 :
Ri,t=[((Pi,t-Pi,t-1+Di,t)/Pi,t-l)/(1+It/100)-1]*100:
(22)
where Ri,t denotes the pre-tax monthly real rate of
return on the stock of the selected firm i
for month=t;
Pi,t denotes the adjusted market price of the
stock of the selected firm i at the end of
month=t (effects of changes in capital and
face values,stock splits, and mergers on
stock prices are adjusted);
Di,t denotes the dividend paid by the
selected firm i during month=t( dividend
payment is leveled for all the
corresponding months.); and
It denotes the U.S. or Japan's monthly
inflation rate from month=t-1 to month=t.
Sources of the data:
Pi,t:Daily Stock Price Record:New York Stock
Exchange, 1986-89;
Daily Stock Price Record:
Over-The-Counter, 1986-89; and
Morgan Stanley, 1986-1989.
Di,t:Moody's Handbook of Common Stock, 1986-89;
and
Moody's Annual Dividend Handbook, 1986-89.
Ik: International Monetary Fund, 1986-1989
1 Strictly
speaking, the after-tax real rates of return must
be calculated.
PAGE 81
Secondly, since C1 denotes either changes in or level of
real consumption of a representative domestic investor, data
of real consumption per capita which are published by the
Government or its agents can be used as good approximations
although the data have the following problems in addition to
the general errors inherent to the statistical methods
employed by the issuers :
1) the inflation rate to adjust the nominal consumption
per capita of a representative domestic investor to
the real consumption per capita is difficult to
identify.
Hence, the Consumer Price Index (CPI) is
used to adjust the nominal consumption per capita as
an approximation;
2) the monthly data of the domestic population are
generally based on the estimation, thus, the real or
nominal monthly consumption per capita may be
different from the actual number;
3) the real consumption in the Consumption-Based CAPM
excludes the consumption of durable goods whereas
some data on the consumption do not clearly separate
the consumption of durable goods from that of nondurable goods and services; 1 and
4) the consumption data of Japan's investors are not
seasonally adjusted, whereas those of U.S. investors
are seasonally adjusted.
1 See
Breeden[1979] and Stulz[1984] for discussions on reasons
of excluding the consumption of durable goods.
PAGE 82
In order to calculate discount rates from U.S. and Japan's
investors' perspectives with minimum effects of the above
problems, the following two formulas and data are used to
obtain the level of the real consumption per capita,
excluding the durable goods consumption, of U.S. and Japan's
investors.
Therefore, the real level of consumption per
capita calculated with the following formulas (23) and (24)
are applicable to Stulz-CCAPM.
Cus,t = Clt / Plt:
(23)
where Cus,t denotes the monthly real consumption
per capita of U.S. investors for month=t;
Clt denotes the total monthly real personal
consumption of non-durable goods and
services for month=t; and
Plt denotes the total resident population in
U.S. for month=t.
Sources of the data:
Clt: U.S.Department of Commerce, Bureau of
Economic Analysis, 1989
Pit: U.S.Department of Commerce, Bureau of the
Census, 1989
k=t
Cj,t = A*(C2t-C3t -C4t)/[ P2t * r (1 + Ik(J)/100)]:
k=1
(23a)
where Cj,t denotes the real monthly consumption per
capita of Japan's investors for month=t;
A denotes a monthly seasonality adjustment
factor based on those used in 1984. For each
month, from January through December, the
following numbers are used as the adjustment
factors:
1.0512, 1.1507, 0.9292, 0.9989,
1.0592, 1.0464, 0.9635, 0.9921,
1.1071, 1.0475, 1.0749, and 0.7255;
C2t denotes the total nominal monthly household
expenditure for month=t;
PAGE 83
C3t denotes the nominal monthly expenditure in
fuel,light, and water charges for month=t;
C4t denotes the nominal monthly expenditure in
clothing and footwear for month=t;
P2t denotes the persons per household for
month=t; and
Ik(J) denotes the Japan's monthly inflation
rates from month=k-1 to month=k
Sources of the Data:
C2t, C3t, C4t, and P2t: The Bank of Japan,
1986-1988
Ik(J): International Monetary Fund,1986-1989
On the other hand, monthly changes in real consumption per
capita for Breeden-CCAPM are calculated with the following
formulas (23b) and (23c) by using the data obtained by the
formulas
(23)
and (23a).
CCus,t = (Cus,t - Cus,t-l) / Cus,t-1:
(23b)
where CCus,t denotes the monthly changes in real
consumption per capita of U.S. investors
for month=t; and
Cus,t denotes the monthly real consumption
per capita of U.S. investors for month=t.
CCj,t = (Cj,t - Cj,t-l)
/ Cj,t-1:
(23c)
where CCj,t denotes changes in real monthly
consumption per capita of Japan's
investors for month=t; and
Cjt denotes the real monthly consumption per
capita of Japan's investors for month=t.
Secondly, a market portfolio, (Rm), and a
real rate of
return on an arbitrary portfolio, (Rp), is approximated to
the pre-tax real rate of return on the domestic market
PAGE 84
portfolio with the assumption that all domestic investors
hold the domestic market portfoliol.
This approximation
enables the Zero-Beta CAPM later to check estimated discount
rates by the CCAPM in some specific conditions.
The
following formulas and data are used to calculate monthly
real rates of return on the U.S. and Japan's domestic market
portfolios:
Mus,t = [(l+Mt(U)/100)/(1+It(U)/100)-1] * 100:
(24)
where Mus,t denotes the real monthly rate of return
on the U.S. domestic market portfolio for
month=t;
Mt(U) denotes the nominal monthly rate of
return on the U.S. domestic market
portfolio for month=t;
It(U) denotes the U.S. monthly inflation rate
from month=t-1 to month=t.
Sources of the data:
Mt(U): Ibbotson Associates, 1989
Ik(U): International Monetary Fund, 1986-1989
Mj,t = [(1+Mt(J)/100)/(1+It(J)/100)-1]
* 100:
(24a)
where Mj,t denotes the real monthly rate of return on
the Japan's domestic market portfolio for
month=t;
Mt(J) denotes the nominal monthly rate of
return on the Japan's domestic market
portfolio for month=t;
It(J) denotes the Japan's monthly inflations
1Strictly speaking, the after-tax real rates of return must
be calculated. However, since covariance of the pre-tax real
rates of return on the risky assets with the real consumption
is divided by the covariance of the pre-tax real rates of
return on the domestic market portfolio with the real
consumption, effects of tax on calculating betas is assumed
to be minor.
PAGE 85
rate from month=t-1 to month=t.
Sources of the data:
Mt(J) : Ministry of Finance,Japan , 1986-1989
Ik(J) : International Monetary Fund, 1986-1989
Thus, the betas of the selected firms are calculated by
using the formulas (20a) and (21a) with the results obtained
above.
However, obtained betas, which are financially
leveraged, must be unleveraged in order to be all equityfinanced betas for the use of VC methodology.
The method of
unleveraging is the same as was discussed in section 2.2. of
Chapter 1 (ESTIMATE OF RISK PREMIUM BY CAPITAL ASSET PRICING
MODEL).
The formula(ll) of unleveraging betas is cited from
the section as follows:
BA = BE / (1 + (1-T) * D/E ):
(11)
Here, 1) the tax rates for U.S. and Japanese firms are
assumed to be 34% and 42%, respectivelyl; and 2) the market
value of the debt of the selected firm is assumed to be total
outstanding amount of long-term debt for 1986 or 1987
whichever the data are available. The sources of the data on
the debt are Moody's Industrial Manual, Moody's International
Manual, and Moody's Bank and Financial Manual. Finally, 3)
the market value of the equity of the selected firms are
calculated by multiplying the number of outstanding shares of
the selected firm during the same period as the period, when
1See Gomi[1984]
for Japanese Tax Systems.
PAGE 86
the data of the outstanding long-term debt are obtained, with
the market price of the stock of the selected firms.
The
sources of the data are the same as those for the debt.
Finally, the all equity-financed betas are obtained in
order to estimate the discount rates.
2.2. ESTIMATING ZCAPM & CCAPM SECURITY MARKET LINE
WITH ORDINARY LEAST SQUARES REGRESSION
In the previous sub-section, ways of calculating the
leveraged and unleveraged ZCAPM and CCAPM betas of the
selected U.S. and Japan's firms are presented.
In this sub-section, ways and issues of estimating the
Security Market Lines of the ZCAPM and CCAPM by using the
obtained results in the previous sub-section are briefly
discussed with the Ordinary Least Squares Regression method.
However, since this thesis does not intend to explain the OLS
Regression method, readers may need to consult statistics
textbooks, such as Dhrymes[1970], Hoel[1954] and etc, which
explain the OLS Regression method.
The equations of the Security Market Lines (SML) of the
ZCAPM and CCAPM were already presented in the beginning of
this chapter.
The following formula (20) and (21),
respectively, express the SML of the ZCAPM and CCAPM.
E(Ri) = E(Rz) + [E(Rm) - E(Rz)]
E(Ri) = E(Rzc)
* Bi:
+ [E(Rp) - E(Rzc)]
* Bic:
(20)
(21)
PAGE 87
As the above formulas show, the SML expresses a linear
relationship between the betas of risky assets and expected
rates of return on the risky assets.
By assuming the SML is
applicable to the betas obtained in the previous sub-section
and the realized rates of return on the selected firms for
the time period from 1986 through 1988, the SML's of the
ZCAPM and CCAPM are estimated by using the OLS Regression
method.
The results of the OLS Regression should be examined in
terms of what the results imply because the OLS Regression
itself is a pure statistical method and does not explain
causes and effects of the results.
The following are points
necessary to be examined.
1) The SML obtained by the OLSR must go through a point
which represents the domestic market portfolio, whose
realized real rate of return is calculated according
to the data used to calculate the betas, and whose
beta must be one(l) by the definition and
assumptions.
The realized monthly rates of return on
the U.S. and Japan's domestic market portfolios are
0.7333% and 2.2274%, respectively. 1
Any
statistically significant deviation from the point
implies that the obtained SML is not appropriate.
2) The slope of the SML is assumed to be positive
1See Tokyo Stock Exchange Market[1989] for another
calculation of the realized monthly rate of return on Japan's
market portfolio. They also show very high rates of return
on the market portfolio.
PAGE 88
because the expected rates of return are assumed to
increase as the betas (or, equivalently, riskiness or
variance of assets ) increases.
However, it is
recognized that, in some periods, the SML for the
historical data could be negative according to the
empirical tests of the CAPM.
If the slope is
negative, the obtained SML is not applicable to
estimate expected (future) rates of return on risky
assets because the negatively-sloped SML represents
historical outcomes.
3) The intercept of the SML with the vertical axis (or,
equivalently, rates of return on risk-free assets)
should be compared to the rates of return on those
"risk-free" financial assets such as T-Bill.
Too
high risk-free rates of return may overestimate or
underestimate risky assets under consideration.
4) The squared correlation coefficients must be large
enough to support the statistical reliability of the
OLS Regression.
By keeping the points above mentioned, the OLS
Regression are applied to the obtained betas and the realized
real rates of return so as to obtain the ZCAPM SML's for U.S.
and Japan's investors, respectively, and the Breeden-CCAPM
and Stulz-CCAPM for U.S. and Japan's investors, respectively,
in total six(6) SML's.
The main data and results will be
presented and discussed in next section.
PAGE 89
3.
RESULTS OF REGRESSION OF ZCAPM AND CCAPM
This section presents the data and results of the OLS
Regression and discusses the obtained SML's, comparing with
those of the ZCAPM obtained by others or each other.
After
checking the obtained SML's with the points mentioned in the
previous section, the SML's are refined in order to be
reasonable enough to be used to estimate discount rates.
3.1. COMPARISON OF OBTAINED ZCAPM
WITH ZCAPM BY FAMA, MACBETH, AND SAKAKIBARA
The leveraged ZCAPM betas and the realized real rates of
returns of the selected U.S. and Japan's firms, which were
calculated according to the procedures earlier discussed are
shown in the Table below.
Then, the data are used for the OLS Regressions so as to
obtain the SML equations.
Simultaneously, the rates of
return on the Zero-beta portfolios are statistically
obtained, but are not confirmed by creating the Zero-beta
portfolios with the observable risky assets.
In the OLS
Regressions, the SMLs are examined with regard to the points
discussed in section 2.2 of this chapter.
PAGE 90
TABLE 1:
Leveraged ZCAPM Betas and Realized Real
Return of the Selected US & Japan's Firms
Leveraged Betas
Monthly Return(%)
----- U.S.----CBI Industries
Centex General
CRSS
Flour Daniel
Foster Wheeler
Jacobs Engineering
Morrison Knudsen
Perini
Stone & Webster
Turner
California REIT
Cenvill
Federal Realty
First Union
Hotel Investment
HRE Properties
IRT Properties
Saul B.F.RL.Inv.
0.79
0.95
1.08
1.25
1.73
0.58
1.25
0.91
1.12
0.85
0.14
0.35
0.62
0.64
0.66
0.13
0.80
0.56
0.97
0.95
3.78
1.68
1.19
3.75
0.46
0.83
1.62
-0.62
-0.95
0.72
0.90
-0.52
-1.36
0.07
1.62
1.99
---- Japan-------Aoki Construction
Fujita Corp
Haseko
Hazama-gumi
Kajima
Kumagai-gumi
Maeda Corp
Ohbayashi Corp
Penta Ocean Const.
Shimizu Construction
Taisei Corp
Daikyo
Mitsubishi Estate
Mitsui Real Estate
Sumitomo R & D
0.68
1.18
1.48
0.40
1.64
0.39
0.95
1.37
1.04
1.24
1.32
0.42
1.60
1.31
1.05
1.63
2.75
3.49
3.05
4.90
1.50
2.51
4.19
3.33
4.73
4.77
0.26
3.53
3.85
0.87
The results of the OLS Regression with the OLS equations
are shown in the Figure 2:
ZCAPM for Japan.
ZCAPM for U.S., and Figure 3:
Because, in the Figure 2, some of the
plotted data are found to be out of a group of the other
PAGE
majority of the data, the OLS Regression was implemented for
those data excluding the extraordinary ones.
the
0
1
ZCAPM BETA
Figure 2:
ZCAPM for U.S.
The result of
91
PAGE 92
4
z
rIw
3
L-
2
z
I0
1
0
0.0
0.5
1.0
1.5
ZCAPM BETA
Figure 3:
ZCAPM for Japan
2.0
PAGE 93
z2
O1
c-
0
LU
I>'0
zI-
-1
0
1
2
ZCAPM BETA
Figure 2a:
Adjusted
ZCAPM for U.S.
PAGE 94
OLS Regression is shown in the Figure 2a: Adjusted ZCAPM for
U.S..
Consequently, the SML equations in terms of monthly
rates of return for the period from 1986 through 1988 are
expressed as follows:
ZCAPM for U.S.:
E(Ri) = 0.0819 + 0.7731 * Bi:
E(Rm) = 0.8550 %
E(Rz) = 0.0819 %
R^2
ZCAPM for Japan:
= 0.182
E(Ri) = 0.2947 + 2.5239 * Bi:
E(Rm) = 2.8186 %
E(Rz) = 0.2947 %
R^2
= 0.552
These SML equations for 1986 to 1988 are compared with
those obtained by Fama,Macbeth[1973],
al.[1988]
and Sakakibara et.
in the following Table 2: Comparison of ZCAPM's.
PAGE 95
Table 2: Comparison of ZCAPM's
period
monthly rates(%)
annualized rates(%)
Rz
Rm
--ZCAPM for U.S.
1935-40
0.17
1941-45
0.12
1946-50
-0.06
1951-55
1.11
1956-60
1.30
1961-6/68
-0.17
1.26
2.40
0.22
1.35
1.89
1.25
2.04
1.44
-0.72
13.32
15.60
-2.04
15.12
28.80
2.64
16.20
22.68
15.00
1935-6/68
0.36
1.21
4.32
14.52
1986-88
0.08
0.86
0.98
10.26
--ZCAPM for Japan
1957-59
0.14
1.40
1.68
16.80
1960-64
1.48
0.91
17.76
10.92
1965-69
0.32
1.20
3.84
14.40
1970-74
2.62
1.44
31.44
17.28
1975-79
0.44
0.87
5.28
10.44
1980-84
0.87
-0.54
10.44
-6.48
-------------------------------------------------------1957-84
0.45
0.85
5.40
10.20
-------------------------------------------------------1986-88
0.29
2.82
3.54
33.82
----------------------------------------------Sources: Data of U.S. ZCAPM for 1935-6/68 are cited from Fama
and Macbeth[1973] and adjusted into the real terms.
Data of Japan's ZCAPM for 1957-59 are cited from
Sakakibara et. al.[1988].
Other data are calculated in this thesis.
By comparing the SML obtained for the period of 19861988 with those by Fama, Macbeth, and Sakakibara for the past
three decades, it is observed that the SMLs obtained for
1986-89 are substantially different from those for the past
three decades with regard to the rates of return on the Zerobeta portfolios and the rates of return on each market
portfolio.
PAGE 96
First of all, the SMLs in U.S. seem to have general
tendency that the slopes of the SMLs are positively steeper
when U.S. economy expanded, such periods as of 1941-1945 and
1961-1968, than when U.S.economy was stagnant, such periods
as of 1946-1950.
For instance, the risk premiums
(differentials of rates of return on the market portfolio and
Zero-beta portfolio) for 1941-1945 and 1946-1950 are 27.36%
and 3.36%, respectively.
Over the three decades, the average
risk premium is 10.20%, which is close to the current risk
premium for 1986 to 1988.
The current risk premium of 9.28%
is likely to correspond to the current stable expansion of
U.S. economy.
However, the rate of return on the Zero-beta
portfolio for 1986-1988, that is, 0.98%, is quite lower than
that on average of 4.32%.
One possible explanation might be
that the average rate of return on Zero-beta portfolio is
inflated by two extremely high rates of return on Zero-beta
portfolios for 1951-1955 and 1956-1960, these are, 13.32% and
15.6%, respectively.
Secondly, the SML in Japan does not seem to have such a
general tendency as was observed for the SML in U.S..
Both
before 1970 when Japan's economy expended with roughly 10%
growth rates, and after 1970 when Japan's economy moderately
expanded with roughly 5% growth rates, positively-sloped and
negatively-sloped SMLs are observed for the five-year subperiods.
Incidentally, the positive and negative slopes of
the SMLs for each sub-period in Table 2 appears mutually.
The current SML for 1986-1988 indicates extremely high rate
PAGE 97
of return on the market portfolio (roughly 30%),
reflecting
the current extraordinary economic expansions which are
compatible to those in 1960's.
As the SML's by Fama, Macbeth, and Sakakibara indicate,
the SML equations
the above Table, the following points are
recognized for various periods considerably fluctuate, not
only in terms of realized real rates of return, but also in
terms of relationships between the betas
(risks of assets)
and realized return. Especially, in periods, such as 1960-64,
1970-74, and 1980-84, the realized return on Japan's ZeroBeta portfolios are higher than the realized return on the
domestic market portfolios.
Moreover, the realized return on
the Zero-Beta portfolios in both countries vary substantially
over time.
For the periods of 1935-88, the realized return
on the Zero-Beta portfolios in U.S. vary between -2.04 % to
15.60 %, and for the periods of 1957-88, the realized return
on the Zero-Beta portfolios in Japan vary between 1.68 % to
31.44 %.
This large fluctuation of the return on the Zero-
Beta portfolios seems to be inconsistent with the concept of
the Zero-Beta portfolio because the Zero-Beta portfolio is
supposed to replace the almost risk-free assets, such as TBill's or Government Bonds whose real rates of interest are
quite stable, compared to those of the Zero-Beta portfolio.
The above argument might indicate that the ZCAPM SML are
more dynamic over time than expected.
Since this thesis is
not intended to pursue the dynamics of the ZCAPM in a pure
finance field, and since this issue is beyond the scope of
PAGE 98
this thesis, this is an obvious research issue for financial
experts to examine in the future.
The importance of this issue to the project evaluation
is what is the appropriate expected rate of return on the
Zero-Beta portfolio and on the domestic market portfolio so
as to estimate the appropriate discount rates, given such
fluctuations.
The most adequate way of estimating discount rates might
be to forecast states of economies for the project's periods
so that the expected rates of return on the Zero-Beta and
domestic portfolios are estimated for the project's periods.
However, it is quite judgmental rather than objective and not
easy to forecast.
In this thesis, the discount rates of the selected U.S.
and Japan's C&E and real estates firms will be calculated by
using the SML's by Fama,Macbeth, and Sakakibara for long-life
projects whose durations are equal to or more than average
business cycles of the home country's economy, and by using
the SML's obtained for 1986-88 for short-life projects whose
durations are less than average business cycles of the home
country's economy.(The average business cycles in U.S. and
Japan are about 50 to 60 months.)
These SML equations are
as follows:
ZCAPM for U.S. ( long term ):
E(Ri) = 4.32 + 10.20 * 8i:
ZCAPM for U.S.( short term ):
(25)
PAGE 99
= 0.98 +
9.28 * 8i:
(26)
E(Ri) = 5.40 +
4.80 * Bi:
(27)
E(Ri)
ZCAPM for Japan( long term ):
ZCAPM for Japan( short term ):
E(Ri)
= 3.54 + 30.28 * Bi:
(28)
3.2. COMPARISON OF OBTAINED TWO CCAPM's:
BREEDEN-CCAPM AND STULZ-CCAPM
The leveraged Breeden- and Stulz-CCAPM betas and the
realized real rates of returns of the selected U.S. and
Japan's firms, which were calculated according to the
procedures earlier discussed are shown in the Tables below.
PAGE 100
TABLE 3: Leveraged Breeden-CCAPM Betas and
Realized Real Return of the Selected Firms
Leveraged Betas
----- U.S.----CBI Industries
Centex General
CRSS
Flour Daniel
Foster Wheeler
Jacobs Engineering
Morrison Knudsen
Perini
Stone & Webster
Turner
California REIT
Cenvill
Federal Realty
First Union
Hotel Investment
HRE Properties
IRT Properties
Saul B.F.RL.Inv.
---- Japan-------Aoki Construction
Fujita Corp
Haseko
Hazama-gumi
Kajima
Kumagai-gumi
Maeda Corp
Ohbayashi Corp
Penta Ocean Const.
Shimizu Construction
Taisei Corp
Daikyo
Mitsubishi Estate
Mitsui Real Estate
Sumitomo R & D
Monthly Return(%)
-1.42
-1.73
-11.64
1.54
5.04
7.06
-4.17
5.29
1.64
3.34
1.92
3.17
-0.86
-3.18
4.11
6.03
0.42
-1.16
0.97
0.95
3.78
1.68
1.19
3.75
0.46
0.83
1.62
-0.62
-0.95
0.72
0.90
-0.52
-1.36
0.07
1.62
1.99
-0.10
-1.71
4.17
0.16
1.29
0.78
5.66
-0.31
0.72
2.84
2.18
0.60
-0.53
4.45
-0.06
1.63
2.75
3.49
3.05
4.90
1.50
2.51
4.19
3.33
4.73
4.77
0.26
3.53
3.85
0.87
PAGE 101
TABLE 4: Leveraged Stulz-CCAPM Betas and
Realized Real Return of the Selected Firms
;------------------------------------------Leveraged Betas
Monthly Return(%)
~----------------------==~-------------------- U.S.----0.97
2.78
CBI Industries
0.95
1.26
Centex General
3.78
-2.43
CRSS
1.68
-3.01
Flour Daniel
1.19
0.79
Foster Wheeler
3.75
-1.58
Jacobs Engineering
0.46
1.62
Morrison Knudsen
0.83
-0.64
Perini
1.62
1.04
Stone & Webster
-0.62
-0.50
Turner
-0.95
-1.91
California REIT
0.72
2.94
Cenvill
0.90
1.64
Federal Realty
-0.52
1.67
First Union
-1.36
4.21
Hotel Investment
0.07
0.22
HRE Properties
1.62
1.53
IRT Properties
1.99
6.03
B.F.RL.Inv.
Saul
~i__---------------------------------------------- Japan-------1.63
0.25
Aoki Construction
2.75
1.48
Fujita Corp
3.49
2.75
Haseko
3.05
0.29
Hazama-gumi
4.90
2.17
Kajima
1.50
0.01
Kumagai-gumi
2.51
0.47
Maeda Corp
4.19
2.36
Ohbayashi Corp
3.33
1.27
Penta Ocean Const.
4.73
1.28
Shimizu Construction
4.77
1.31
Taisei Corp
0.26
0.78
Daikyo
3.53
3.30
Mitsubishi Estate
3.85
1.73
Mitsui Real Estate
0.87
1.04
D
&
R
Sumitomo
---------------------------------------------
The results of the OLS Regression are shown in the
Figure 4: Breeden-CCAPM for U.S., Figure 5: Breeden-CCAPM for
Japan, Figure 6: Stulz-CCAPM for U.S., and Figure 7: Stulz-
PAGE 102
CCAPM for Japan.
Because, in the Figure 4 and 6, some of the
plotted data are found to be out
-2
-20
-10
0
BREEDEN-CCAPM BETA
Figure
4:
Breeden-CCAPM
for U.S.
PAGE 103
I
13
1
y = 2.7780 + 0.18320x
013
B0
-
•
·
"
7
I
0
RA2 = 0.071
0B
0
"
1
"
I
I
1
·
·
·
4
BREEDEN-CCAPM BETA
Figure 5:
Breeden-CCAPM for Japan
PAGE 104
-4
-2
0
2
4
6
STULZ-CCAPM BETA
Figure
6:
Stulz-CCAPM for U.S.
PAGE 105
0
1
2
3
STULZ-CCAPM BETA
Figure
7:
Stulz-CCAPM
for Japan
4
PAGE 106
y = 0.74676 + 1.0729e-2x
,
RA2 = 0.002
S
B5
BS
El
t13
0B
1
·
-6
I
-4
-
-
-
-
-2
-
-
0
-
-
-
-
2
·
-
·
·
4
-
-
-
6
BREEDEN-CCAPM BETA
Figure
4a:
Adjusted
Breeden-CCAPM for
U.S.
PAGE 107
-2
-1
0
1
2
STULZ-CCAPM BETA
Figure
6a:
Adjusted
Stulz-CCAPM
for
U.S.
PAGE 108
of a group of the other majority of the data, the OLS
Regressions were implemented for those data excluding the
extraordinary ones.
The results of the OLS Regressions are
shown in the Figure 4a: Adjusted Breeden-CCAPM for U.S.,
and
in the Figure 6a: Adjusted Stulz-CCAPM for U.S..
The results of the Breeden-CCAPM shown in the Figure 4a
and 6 indicates that the obtained SML's are almost nonsensitive to the betas. ( The annualized risk premiums of the
U.S. and Japan's
domestic market portfolios are marginally
0.13 % and 2.20 %, respectively, and the squared correlation
coefficients of the SML's are 0.002 and 0.071,
respectively. )
This results do not necessarily result in
the invalidity of the Breeden-CCAPM because the most reliable
consumption data currently available are not considered as
accurate as those data of the capital markets, and moreover,
there is a fundamental question of which categories of the
consumptions are relevant to the individual's utilities and
of how these categories of the consumptions affect the
individual's utilities.
Although Breeden and Stulz recommend
to exclude durable goods from the relevant consumptions, it
may not be precise enough to distinguish those relevant to
the individual's utilities from those irrelevant.
Because
some of the non-durable goods and services, such as food
indispensable for lives, do not seem to affect the
individual's utilities.
According to my various regressions
by combining various categories of the consumptions, the
results were heavily affected by the combination of the
PAGE 109
consumption categories.
Unless these questions are answered,
the Breeden CCAPM may not be correctly applied.
Because of
these questions, at least in this thesis, the Breeden-CCAPM
may not be adequate to apply so as to estimate the discount
rates for the project evaluation.
On the other hand, the results of the Stulz-CCAPM shown
in the Figure 6a and 7 show much more reasonable
relationships between the realized rates of return and the
betas.
It is not clear why the Stulz-CCAPM shows the
reasonable relationships between the returns and betas than
the Breeden-CCAPM.
One of several possible reasons for this
result might be that the changes in the consumptions are too
sensitive measures, compared to the changes in the returns on
the assets so that the relationships are clouded out by the
excess sensitivities.
In this thesis, the Stulz-CCAPM will be used to estimate
discount rates for the project evaluation because the squared
correlation coefficients of the Stulz-CCAPM are statistically
more significant that those of the Breeden CCAPM. ( The
squared correlation coefficients of the Stulz-CCAPM are 0.35
and 0.303 as opposed to 0.002 and 0.071 of the BreedenCCAPM.)
The Stulz-CCAPM SML equations expressed in terms of
annualized real rates are as follows:
CCAPM for U.S. :
E(Ri) = 5.40
+
3.65 * Bi:
(29)
CCAPM for Japan:
E(Ri) = 22.79 +
9.88 * Bi:
(30)
PAGE 110
However, as was discussed for the ZCAPM, the above SML
equations are applicable only for short-term projects which
terminate within the business cycle of the home country's
economy.
Since the tests of CCAPM for the long time horizon
is not currently available, a precise test of the CCAPM is
expected in the future.
PAGE 111
4.
MEASUREMENT OF UNLEVERED BETAS OF CONSTRUCTION INDUSTRY
AND REAL ESTATE INDUSTRY OF THE UNITED STATES AND JAPAN
This section presents the results of the calculations of
unleveraged betas of the selected firms which are engaged in
the construction and real estate industries in the U.S. and
Japan.
Also discussed are the obtained unleveraged betas in
terms of the sensitivities to the market movements and the
real consumption.
However, it is not easy to discuss the
unleveraged betas in relation to the real consumptions,
because 1) the real consumption data used in the calculations
are, although considered to be the most reliable data
currently available, likely to be, more or less, in error in
the senses discussed in the previous section, and 2) the
restrictive assumptions made for the calculations don't
completely reflect the real world so that the obtained
unleveraged betas might be, more or less, biased.
In order to clearly discuss the sensitivities of the
obtained betas to the real consumption, 1) the unleveraged
betas calculated according to the Breeden-CCAPM will be
presented only for reference because the non-sensitivities of
the betas, and 2) the unleveraged betas calculated according
to the Stulz-CCAPM will be compared with those calculated
according to the ZCAPM by using the identical data.
This
comparison can make it possible to understand how different,
in international setting, the asset pricing based on the
consumption maximization (Consumption-Based CAPM) is from
PAGE 112
that based on the wealth maximization (Zero-Beta CAPM),
though, in economic theory, both ZCAPM and CCAPM are
identical.
In addition, in order to clarify the differences of the
two asset pricings in international setting, the selected
construction and engineering firms in the U.S. and Japan are
respectively separated into two groups, these are, foreignoriented firms which undertake substantial foreign contracts
and domestic-oriented firms which undertake insignificant
foreign contracts. The selected real estate firms are assumed
to operate primarily in the domestic markets.
The groupings
of the C&E firms are as follows:
1) foreign-oriented firms:
U.S.------- Flour Daniel, Foster Wheeler, Stone &
Webster, CBI Industries, and Perini
(the weighted average ratio of the
foreign contracts to the entire
contracts is 29%.);
Japan------ Aoki Construction, Hazama-gumi,
Kumagai-gumi, and Ohbayashi Corp.
(the weighted average ratio of the
foreign contracts to the entire
contracts is 11%.);
2) domestic-oriented firms:
U.S.------- CRSS, Morrison Knudsen, Centex General,
Turner, and Jacobs Engineering
(the weighted average ratio of the
foreign contracts to the entire
contracts is 2%.); and
Japan------ Fujita Corp., Haseko, Kajima, Maeda
Corp., Penta Ocean Const., Shimizu
Construction, and Taisei Corp.
(the weighted average ratio of the
foreign contracts to the entire
contracts is 3%.).
PAGE 113
At first, the unleveraged betas of the U.S. construction
and real estate firms are presented and discussed from the
U.S.(domestic) and
Japan's(foreign) investors' viewpoints,
and secondly, the unleveraged betas of the Japan's
construction and real estate firms are presented and
discussed from the U.S.(foreign) and Japan's(domestic)
investors' viewpoints.
4.1.
UNLEVERED BETAS OF U.S. CONSTRUCTION AND REAL ESTATE
INDUSTRY FROM U.S. AND JAPAN'S INVESTORS' VIEWPOINTS
The following Table-5 shows the obtained unleveraged
betas of the U.S. construction and engineering firms
according to the Zero-Beta CAPM and Consumption CAPM.
Table-5: Unleveraged Betas of U.S. C&E Firms
CAPM
ZCAPM
Stulz-CCAPM
firms' orientation
(foreign/domestic)
investors' consumption base
U.S.
Japan
foreign
domestic
0.95
0.82
0.37
0.09
average
0.89
0.24
foreign
domestic
0.18
-0.30
0.90
0.46
average
-0.06
0.68
1.94
-1.48
-1.83
0.29
0.23
-0.77
Breeden-CCAPM foreign
domestic
average
PAGE 114
The following points are observed in the above table:
1) the sensitivities of stocks of the selected U.S. C&E
firms to the stock market movements and the real
consumptions are substantially different with each
other.
The betas calculated with the ZCAPM are
higher for the U.S. investors, whereas the betas with
the Stulz-CCAPM are higher for Japan's investors;
2) the Stulz-CCAPM tells that, for the U.S. investors,
the U.S. E&C firms are almost risk-free whereas the
ZCAPM tells that the U.S. E&C firms are almost as
risky as the domestic market portfolio;
3) the Stulz-CCAPM shows that, for Japan's investors,
the U.S. E&C firms are riskier than the ZCAPM; and
4) the Breeden-CCAPM indicates that, for Japan's
investors, the U.S. E&C firms are negatively risky as
opposed to the Stulz-CCAPM.
However, it should be noted that since the unleveraged
betas are relative sensitivity measures of the riskiness of
the assets under consideration to the market movements
(ZCAPM) or the real consumption (CCAPM), the betas alone
cannot determine discount rates used for project evaluations.
This is because the ZCAPM and CCAPM have different expected
rates of return on the zero-beta portfolio or safety
portfolio uncorrelated with the real consumptions as was
discussed in section 3. of this chapter. (This issue will be
discussed in next section.)
PAGE 115
The next Table-6 shows the obtained unleveraged betas of
the U.S. real estate firms according to the ZCAPM and CCAPM.
Table-6: Unleveraged Betas of U.S. Real Estate Firms
CAPM
firms' orientation
(foreign/domestic)
investors' consumption base
U.S.
Japan
ZCAPM
-------
0.34
0.14
Stulz-CAPM
-------
1.15
0.57
Breeden-CAPM
-------
1.27
0.09
The following results are obtained from the above table:
1) the sensitivities of stocks of the selected U.S. real
estate firms to the stock market movements and the
real consumptions are different with each other.
A
general tendency is observed that the CCAPM betas are
larger than the ZCAPM betas, except for the BreedenCCAPM betas from Japan's investors' perspectives; and
2) the betas calculated from the U.S. (domestic)
investors' viewpoints are larger than those from the
Japan's (foreign) investors' viewpoints.
By combining the observations obtained from the
unleveraged betas of the U.S. construction and engineering
firms with those of the U.S. real estate industry, the
following might be argued:
1) the U.S. C&E and real estate firms which are
relatively purely engaged in the domestic activities
PAGE 116
are less risky to the Japan's (foreign) investors
than to the U.S.
(domestic) investors in terms of the
sensitivities both to the investors' relevant market
movements and to the investors' real consumptions.
Therefore,
"international naive diversification
effects" might be effectively achieved in case that
the Japan's investors invest on the U.S. assets
related to the U.S. construction and real estate
industries; and
2) the U.S. real estate industries are more sensitive to
the real consumptions of both the U.S. (domestic)
investors and the Japan's (foreign) investors rather
than to the U.S. and Japan's market movements.
This
might suggest that the U.S. real estate industry be
riskier than it is evaluated with the ZCAPM.
However, it should be also noted that the above
arguments should not be generalized, but rather, they should
be interpreted as such that represent the current(1986-88)
relationships between the risk and return of the U.S. and
Japan's assets from each other's perspectives. An important
issue of how the relationship might change is beyond the
scope of this thesis.
4.2.
UNLEVERED BETAS OF JAPAN'S CONSTRUCTION AND REAL ESTATE
INDUSTRY FROM U.S. AND JAPAN'S INVESTOR'S VIEWPOINTS
PAGE 117
The following Table-7 shows the obtained unleveraged
betas of the Japan's construction and engineering firms
according to the ZCAPM and CCAPM.
Table-7: Unleveraged Betas of Japan's C&E Firms
CAPM
firms' orientation
(foreign/domestic)
ZCAPM
investors' consumption base
U.S.
Japan
foreign
domestic
0.05
0.29
0.63
1.12
average
0.20
0.94
--------------------------------------------
--------------------------------------------------
Stulz-CCAPM
foreign
domestic
2.78
4.99
0.67
1.34
-----------------------------------------------
average
4.19
1.10
--------------------------------------------------
Breeden-CCAPM foreign
domestic
-2.63
1.30
0.11
1.98
-----------------------------------------------
average
-0.13
1.30
------------------------------------------------------------------------------------------------
The following are observed in the above table:
1) the sensitivities of stocks of the selected Japan's
C&E firms to the stock market movements and the real
consumptions are substantially different to the U.S.
investors (the Stulz-CCAPM betas are considerably
larger than the ZCAPM betas for U.S. investors),
whereas the ZCAPM and Stulz-CCAPM betas the stock are
almost unchanged to Japan's investors;
2) the ZCAPM betas calculated from the U.S.
(foreign)
investors' viewpoints are smaller than those from the
PAGE 118
Japan's (domestic) investors' viewpoints whereas the
Stulz-CCAPM betas from the U.S. (foreign) investors'
viewpoints are larger than those from the Japan's
(domestic) investors' viewpoints.
Therefore, in
relation to the U.S. consumptions, the Japan's
construction industry would be quite riskier to the
U.S.(foreign) investors than the ZCAPM predicts; and
3) a general tendency is observed that the betas of the
foreign-oriented Japan's C&E firms are smaller than
those of the domestic-oriented firms, whereas the
opposite tendency was observed for the U.S. E&C
firms.
The following Table-8 shows the obtained unleveraged
betas of the
Japan's real estate firms according to the
ZCAPM and CCAPM.
Table-8: Unleveraged Betas of Japan's Real Estate Firms
-------------------------------------------------
CAPM
firms' orientation
(foreign/domestic)
investors' consumption base
U.S.
Japan
----------------==~II~~-----------------------
ZCAPM
-------
0.36
0.94
-------
3.20
1.47
-------------------------------------------------------------
Stulz-CCAPM
---------------------------------------------------
Breeden-CCAPM
-------
6.64
The following are observed in the above table:
1) as is
the case with the Japan's construction
0.85
PAGE 119
industry, the sensitivities of stocks of the selected
Japan's real estate firms to the U.S. (foreign) real
consumption is substantially larger (10 time) than to
the U.S. markets; and
2) the ZCAPM betas calculated from the U.S. (foreign)
investors' viewpoints are smaller than those from the
Japan's (domestic) investors' viewpoints whereas the
Stulz-CCAPM betas from the U.S. (foreign) investors'
viewpoints are larger than those from the Japan's
(domestic) investors' viewpoints.
In this sense, the
Stulz-CCAPM indicate the Japan's real estate industry
is riskier than the ZCAPM might indicate.
By combining the observations obtained from the
unleveraged betas of the Japan's construction and engineering
firms with those of the Japan's real estate industry, the
following might be argued:
1) the Japan's C&E and real estate firms might be
riskier in relation to the real consumptions of the
U.S. (foreign) investors than in relation to the U.S.
market movements.
However, the ZCAPM indicates that,
for U.S. investors, the Japan's C&E and real estate
firms are not risky in relation to the U.S. market
movements.
If the Stulz-CCAPM prevails, the
"international diversification effects" might
be marginal, but still be achievable to some extent
in case that the U.S. investors invest in Japan's
PAGE 120
assets related to the Japan's construction and real
estate industries; and
2) the Japan's construction and real estate industries
are more sensitive to the real consumptions of the
U.S.
(foreign) investors and rather than those of the
Japan's investors.
For the Japan's investors, the
ZCAPM and Stulz-CCAPM do make little difference.
This might suggest that the Japan's construction and
real estate industries covary well with the U.S. real
consumptions, or that the Japan's real consumption
pattern covary well with the Japan's market
movements.
However, it should be also noted that the above
arguments should not be generalized, but rather, they should
be interpreted as those representing the current states of
the industries, given the restrictive conditions mentioned in
the previous section.
PAGE 121
5.
ESTIMATE OF DISCOUNT RATES FOR CASH FLOWS GENERATED BY
CONSTRUCTION AND REAL ESTATE INDUSTRY OF U.S. AND JAPAN
This section presents the discount rates estimated by
using the obtained unleveraged betas for cash flows generated
by the construction and real estate industries of the U.S.
and Japan, and discusses the effects of the discount rates on
the international projects evaluations.
As is similar to the previous section, the discount
rates by the Stulz- and Breeden-CCAPM are compared with those
by the ZCAPM.
Before presenting the estimated discount
rates, six(6) SML equations which were derived in section 3
of this chapter are cited below.
ZCAPM for U.S. (long term):
E (Ri)
4.32 + 10.20 * Bi:
(25)
0.98 +
9.28 * Bi:
(26)
5.40 +
4.80 * Bi:
(27)
3.54 + 30.28 * Bi:
(28)
5.40 +
3.65 * Bi:
(29)
= 22.79 +
9.88 * 8i:
(30)
ZCAPM for U.S.(short term):
E(Ri)
ZCAPM for Japan(long term):
E(Ri)
ZCAPM for Japan(short term):
E(Ri)
CCAPM for U.S.(short term) :
E (Ri)
CCAPM for Japan(short term):
E(Ri)
PAGE 122
The following points had better be noted here again in
order to quickly review the above six SML equations:
1) the ZCAPM formulas (25) and (27) were derived from
the empirical tests by Fama, Macbeth, and Sakakibara
for about 30 years time frame.
Thus, these equations
are used for the long-lived projects;
2) the ZCAPM formulas (26) and (28) were derived from
the empirical tests by myself for recent three(3)
years time frame (1986-1988).
Thus, these equations
are used for the short-lived projects currently under
consideration;
3) the Stulz-CCAPM formulas (29) and (30) were also
derived from the empirical tests by myself for recent
three(3) years time frame (1986-1988).
Thus, these
equations are used for the short-lived projects
currently under consideration;
4) the Stulz-CCAPM formulas for the long-lived projects
are not presented here because this requires
substantial number of data and time which is beyond
this thesis; and
5) the Breeden-CCAPM are excluded due to the nonsensitivities of the betas earlier discussed.
In the following two sections, real discount rates of
the U.S. and Japan's construction and real estate industries,
which are calculated by using the above six SML equations and
the unleveraged betas presented in the previous sections, are
PAGE 123
presented from the U.S. and Japan's investors' viewpoints,
and the effects of the discount rates on project evaluations
are discussed.
5.1.
DISCOUNT RATES OF U.S. CONSTRUCTION AND REAL ESTATE
INDUSTRY FROM U.S. AND JAPAN'S INVESTOR'S VIEWPOINTS
The following Table-9 shows the real discount rates of
the U.S. construction and engineering firms according to the
ZCAPM and CCAPM SML equations (25) through (30).
Table-9: Real Discount Rates of U.S. C&E Firms (%)
CAPM
firms' orientation
(foreign/domestic)
ZCAPM
(long-term)
investors' consumption base
U.S.
Japan
foreign
domestic
14.01
12.68
7.18
5.83
average
13.35
6.55
9.80
8.59
11.29
6.27
9.24
10.81
6.06
4.31
31.68
27.33
5.18
29.51
ZCAPM
foreign
(short-term) domestic
average
Stulz-CCAPM
foreign
(short-term) domestic
average
The following points are observed in the above table:
1) a general tendency in the Table 9 through 12 is
observed that the ZCAPM, regardless of short-term or
long-term, estimates lower discount rates for the
PAGE 124
foreign investors, whereas the Stulz-CCAPM (shortterm) consistently estimates higher discount rates
for Japan's investors.
This is due to the extremely
high expected rate of return on the safety
portfolio uncorrelated with the real consumptions for
Japan's investors. (The high rates of return on the
safety portfolios were observed in both U.S. and
Japan in the past. See section 3 of this chapter.)
Thus, the short-term Stulz-CCAPM heavily reflect the
current state of Japan's economy by increasing the
required returns, whereas the ZCAPM discount rates do
not;
2) in the long-run, Japan's (foreign) investors can
expect substantially high values if they invest in
the U.S. assets related to the construction
industries due to lower discount rates for Japanese
than those for U.S. investors, whereas, in short-run,
no significant advantage to Japan's investors are not
recognized; and
3) whether the U.S. C&E firms are foreign-oriented or
domestic-oriented does make little differences in the
real discount rates of the foreign-oriented and
domestic-oriented C&E firms, regardless of the ZCAPM
and CCAPM whereas the unleveraged betas are heavily
affected by the business orientations of the U.S. C&E
firms.
PAGE 125
The next Table-10 shows the real discount rates of the
U.S. real estate firms according to the ZCAPM and StulzCCAPM.
Table-10: Real Discount Rates of U.S. Real Estate Firms (%)
CAPM
firms' orientation
(domestic only)
investors' consumption base
U.S.
Japan
ZCAPM
(long-term)
7.79
6.07
ZCAPM
(short-term)
4.14
7.78
Stulz-CCAPM
(short-term)
9.60
28.42
The following are observed in the above table:
1) no significant difference between discount rates by
the long-term and short-term discount rates is
observed for U.S. and Japan's investors, though, the
long-term investment in the U.S. real estate
industries is more valuable to Japan's investors than
the short-term investment as is the same with the U.S
C&E firms;
and
2) the discount rates calculated by the Stulz-CCAPM from
Japan's investors' viewpoints are substantially
large, reflecting the current state of Japan's
economy, as is the case with the U.S. C&E firms.
By combining the observations obtained from the real
discount rates of the U.S. construction and engineering firms
PAGE 126
with those of the U.S. real estate industry, the following
might be argued:
1) as the long-term investment, the U.S. C&E and real
estate firms, regardless of whether or not domesticoriented, are more valuable to the Japan's
(foreign)
investors than to the U.S. (domestic) investors.
Therefore,
"international diversification effects"
would be achieved in case that the Japan's investors
invest on the U.S. assets related to the U.S.
construction and real estate industries if unique
risks are well diversified away; and
2) as the short-term investment, the U.S. construction
and real estate industries do not provide any
significant advantage to either U.S. or Japan's
investors; and
3) the short-term Stulz-CCAPM heavily reflects the
current state of Japan's economy, increasing the
required rates of return for Japan's investors.
5.2.
DISCOUNT RATES OF JAPAN'S CONSTRUCTION AND REAL ESTATE
INDUSTRY FROM U.S. AND JAPAN'S INVESTORS' VIEWPOINT
The following Table-11 shows the real discount rates of
the Japan's construction and engineering firms according to
the ZCAPM and Stulz-CCAPM.
PAGE 127
Table-11: Real Discount Rates of Japan's C&E Firms (%)
---------------------------------------------investors' consumption base
firms' orientation
CAPM
Japan
U.S.
(foreign/domestic)
~i----------------------------------------------8.42
4.83
foreign
ZCAPM
10.78
7.28
(long-term) domestic
----------------------------------------------9.91
6.36
average
--------------------------------------------------22.62
1.44
foreign
ZCAPM
37.45
3.67
(short-term)domestic
----------------------------------------------32.00
2.84
average
--------------------------------------------------29.41
15.55
foreign
Stulz-CCAPM
36.03
23.61
(short-term)domestic
----------------------------------------------33.66
20.69
average
~~=I=====
--------------------------------------
The following points are observed in the above table:
1) for U.S. investors, investing in the Japan's C&E
firms would generate substantial values, regardless
of the long-term or the short-term;
2) the short-term ZCAPM and Stulz-CCAPM estimate the
real discount rates of Japan's E&C firms to be very
high for Japan's investors, reflecting the current
state of Japan's economy; and
3) the short-term Stulz-CCAPM estimates very high
discount rates not only for Japan's investors but
also for U.S. investors.
The next Table-12 shows the real discount rates of the
Japan's real estate firms according to the ZCAPM and CCAPM.
PAGE 128
Table-12:Real Discount Rates of Japan's Real Estate Firms (%)
~~~-----~----------------------------------------investors' consumption base
firms' orientation
CAPM
Japan
U.S.
(domestic only)
9.91
7.99
(long-term)
ZCAPM
----------------------------------------------------
Stulz-CCAPM
4.32
(short-term)
32.00
----------------------------------------------------
17.08
Breeden-CCAPM (short-term)
37.31
The following points are observed in the above table:
1) for U.S. investors, investing in the Japan's real
estate firms would
generate substantial values,
regardless of the long-term or the short-term,
similarly to investing in Japan's C&E firms;
2) the short-term ZCAPM and Stulz-CCAPM estimate the
real discount rates of Japan's real estate firms to
be very high for Japan's investors, reflecting the
current state of Japan's economy; and
3) the short-term Stulz-CCAPM estimates very high
discount rates not only for Japan's investors but
also for U.S. investors.
By combining the observations obtained from the real
discount rates of the Japan's construction and engineering
firms with those of the Japan's real estate industry, the
following might be argued:
1) for U.S. investors, like Japan's investors' investing
in the U.S. C&E and real estate firms, investing in
Japan's C&E and real estate firms are more valuable
PAGE 129
than for Japan's investors, regardless of short-term
or long-term. Therefore, "international
diversification effects" would be effectively
achieved in case that the U.S. investors invest on
the Japan's assets related to the Japan's
construction and real estate industries; and
2) the short-term Stulz-CCAPM reflects the current
states of economies strongly so that the estimated
discount rates are generally high.
Especially for
U.S. investors, the short-term ZCAPM and Stulz-CCAPM
estimate totally different level of discount rates.
PAGE 130
6.
EVALUATION OF SAMPLE PROJECT BY USING OBTAINED DISCOUNT
RATES
In this section, a simple imaginary project is evaluated
by using the real discount rates calculated in the previous
sections.
A main purpose of this section is to present
effects of the discount rates for the U.S. and Japan's
investors on the values of the project.
Therefore, the
project setting is quite simplifying rather than realistic.
The U.S.-based IBN Corporation and Japan-based SOMY
Corporation now face opportunities of investing on identical
real estate projects both in the U.S. and in Japan.
The real estate project in the U.S. requires $100
million for the initial capital expenditure, and from one
year later on to the 20th year, the project generates net
cash flows of $12 million in each year in real terms.
On the
other hand, the real estate project in Japan requires Y20
billion($100 million at the real exchange rate of Y200/$) for
the initial capital expenditure, and from one year later on
to the 20th year, the project generates net cash flows of
Y2.4 billion($12 million at the real exchange rate of Y200/$)
in each year in real terms.
Therefore, if the real exchange rate is unchanged over
the project period, the cash flows of both projects are
identical. In addition to the assumption, if the real
discount rates for the U.S. and Japan's investors are the
PAGE 131
same, the values of both projects would be exactly the same
to the IBN and SOMY Corporation.
However, the following assumptions are made for the
evaluation: 1) the real exchange rate changes from Y200/$ at
the time of the capital expenditures to Y150/$ at the end of
the projects with a constant rate (certainty of the foreign
exchange) ; and 2)the real discount rates are those
calculated in the previous section by the long-term & shortterm ZCAPM and Stulz-CCAPM.
The implications of these
assumptions are 1) the U.S. dollar depreciates against the
Japanese Yen in real terms so that the U.S. investors have
opportunities of benefiting from the investment in Japan, but
Japan's investors might loose by investing in U.S. assets
simply due to the real depreciation of Yen ; 2) the value of
both projects would be different, depending on who would
invest and on which discount rates to use, the ZCAPM or
Stulz-CCAPM.
Table-13: V.C. of Real Estate Projects (in U.S. Dollar)
==
----------------------------=========L~-------------------------
CAPM
ZCAPM
(long-term)
project
location
investors' consumption base
SOMY(Japan)
IBN(U.S.)
(million $)
U.S.
Japan
19.68
36.91
21.25
2.80
U.S.
Japan
61.08
81.57
6.85
-62.25
U.S.
Japan
5.02
-26.50
-60.60
-67.90
----------------------------------------
ZCAPM
(short-term)
----------------------------------------
Stulz-CCAPM
(short-term)
PAGE 132
The following could be concluded in the above table:
1) the long-term V.C. of the identical real estate
projects in U.S. and Japan are positive for both U.S.
and Japan's investors, but the values of the projects
are larger to the foreign investors than to the
domestic investors.
In spite of the assumption that
U.S. dollar depreciates against Japanese Yen over the
project periods, Japan's investors would benefit more
from investing in the U.S. real estate project;
2) the short-term ZCAPM V.C. of the identical real
estate projects in U.S. and Japan are positive for
U.S. investors, but for Japan's investors, only the
project in U.S. has a positive value. However, the
values of both projects in U.S. and Japan are much
higher to U.S. investors than to Japan's investors.
Therefore, if Japan's investors now buy U.S. real
estate, and sell it soon, at latest before Japan's
current economic expansion declines, expected payoffs
to the investors would be smaller than those in case
the investors buy and sell Japan's real estate in
short periods.
3) the short-term Stulz-CCAPM V.C. of the identical real
estate projects in U.S. and Japan are negative for
Japan's investors, but for U.S. investors, only the
project in U.S. has a positive value. However, the
values of both projects in U.S. and Japan are much
lower to Japan's investors than to U.S. investors.
PAGE 133
This result implies that the short-term Stulz-CCAPM
responses to the current states of both economies in
very sensitive manners.
As is shown in this sample project evaluation, the
international long-term investments are generally beneficial
to foreign investors, whereas the short-term international
investments depend on the current states of economies.
PAGE 134
6.
CONCLUSIONS
According to the results of the previous sections in
this chapter, the following general conclusions might be
argued:
1) the values of the international projects are not
identical to those who participate in the projects
across borders even if there exists no foreign
exchange risks.
This is because the underlying
segmented economies where the investors live
create unique circumstances determining the risks of
the projects and because the real consumption
patterns of the investors are regional and segmented.
Therefore, it would be very dangerous to evaluate the
international projects from one country's investors'
viewpoint, but rather, the international projects
should be assessed by using the asset pricing models
corresponding to the investors' relevant riskdeterminant environments;
2) in this thesis, the long-term CCAPM cannot be
presented due to the limitations on data and
difficulties inherent to searching for the long-term
CCAPM. However, since the real consumption patterns
affect the valuations of the international projects,
the long-term CCAPM should be also established as the
international asset pricing model.
In doing so, the
PAGE 135
real consumption data should be examined very
carefully to avoid misleading factors and artificial
erroneous estimations in the data;
3) "international diversification effect" had better be
considered as a long-term basis, but not as a shortterm basis, because the short-term international
investment is largely affected by the current states
of economies measured with such as real growth rates
of GNP or industrial sectors, although
diversification effects can be expected. Therefore,
careful examinations of the underlying conditions
affecting the project evaluation should be
implemented, especially in case of the short-term
international investment:
4) a domestic project which is believed to have
substantially negative V.C. for the domestic
investors might turn out to be positive if it is
financed, fully or partially,
by foreign investors.
In this sense, internationally financing domestic
projects might benefits not only the investors but
also those who live domestically by vitalizing the
domestic economy.
In coordinating the international
financing, the V.C. with the CAPM or other
appropriate international asset pricing models would
help all participants in the project fairly assess
their benefits.
PAGE 136
In next chapter, the other critical issue ---
the
foreign exchange exposures --- is discussed and the effects
of the FX risks on the project evaluations are tried to be
measured.
CHAPTER 4
EVALUATING FOREIGN EXCHANGE EXPOSURE
PAGE 138
0. INTRODUCTION
This chapter discusses Foreign Exchange(FX) exposures
and effects of the FX exposures on values of international
projects and, finally, conceptually incorporates the FX risks
into the V.C. methodology.
The purpose of conceptually
incorporating the FX risks into V.C. formula is to provide an
analytical and easy-to-use general formula of cash flow
components or risk premiums associated with the FX risks so
that users of the V.C. methodology can independently evaluate
the effects of the FX risk components according to
assumptions and forecasts made on the nominal and real
foreign exchange rates.
However, as was discussed in Chapter
2, since there is no universal V.C. formula applicable to any
type of project in a sense that cash flow components and
risks differ project-by-project, users are assumed to modify
the general V.C. formula to match the project cash flow
components.
Before getting into the discussion, some clarifications
of the FX exposures examined in this chapter is necessary.
These are as follows:
1) this chapter discusses only the economic FX exposures
as opposed to the accounting FX exposures because
only the economic FX exposures are relevant to values
PAGE 139
of projects; 1
2) this chapter is based on the assumption that
corporations' hedging the FX exposures is rational
because of imperfections in the international
financial markets which impact such aspects as
corporate bond ratings, costs of capital and so
forth.
(However, the finance theory based on the
perfect capital market does not justify the
corporations' FX risk hedging because investors can
diversify away the FX risks with less cost than
corporations.) 2 ; and
3) this chapter assumes that the corporation's FX risk
hedge is determined by mean-variance trade-off of an
entire portfolio which the corporation currently
holds plus a new project under consideration.
In
this sense, the FX risk management cannot be
discussed without looking into the corporation's
entire portfolio,
although this chapter does not
discuss the entire portfolio.
In this chapter, first of all, the foreign exchange
exposures in international projects are briefly reviewed in
1 See
Choi and Mueller[1984], Eiteman and Stonehill[1989], and
Shapiro[1989] for detailed discussions on the accounting FX
exposures.
2 See
Dufey and Srinivasulu[1984] for a discussion on the
corporation's FX risk management.
111~--
PAGE 140
terms of contractual and non-contractual cash flows.
Secondly, hedging strategies -- operational and financial -are briefly reviewed.
And finally, a modified V.C. formula
is proposed to conceptually incorporate the FX risks.
=En
PAGE 141
1.
REVIEW FOR FOREIGN EXCHANGE EXPOSURE
This section reviews the FX exposures on contractual and
non-contractual cash flows, respectively.
This is because 1)
the FX exposures on these two types of cash flows are quite
different in nature and 2) distinguishing the FX risks on the
two types of cash flows is necessary to evaluate the effects
of the FX risks on these cash flows in different ways
appropriate to the nature of the FX risks.
1.1.
FOREIGN EXCHANGE EXPOSURE ON CONTRACTUAL CASH FLOWS
The FX exposures on contractual cash flows, which are
fixed by contract and denominated in foreign currencies, are
sensitive to expected or unexpected changes in nominal
exchange rates rather than directly to real exchange rates.
Therefore, the FX exposures on the contractual cash flows are
grouped into two risks; these are, the FX risks associated
with the expected changes in the nominal exchange rates and
those associated with the unexpected changes in the nominal
exchange rates.
( Inflation risks are excluded from the two
groups because 1) the inflation risks are not necessarily
inherent to the cash flows denominated in foreign currencies,
2) the inflation risks are assumed to be minor due to
offsetting effects of the inflations of various countries if
the differentials of the inflation rates among relevant
countries are close, and 3) the real exchange rate analysis
I
_
PAGE 142
to follow takes direct account of inflation differentials.
However, long or short positions in soft currencies are very
sensitive to the inflation risks so that the inflation risks
must be carefully treated when soft currencies are
involved. 1 )
The expected changes in the nominal exchange rates are
defined as those homogeneously expected by all investors
participating in the perfect capital market. Hence, I assume
that the expected changes in the nominal exchange rates are
reflected directly in forward exchange rates for short
periods, and indirectly in the term structures of long-term
government bonds or Eurocurrency interest rates which can be
converted into expected changes in the nominal exchange rates
by using the IFE formula(15). 2
On the other hand, the unexpected changes in the nominal
exchange rates are defined as those which are not anticipated
by the market.
However, since the unexpected changes in the
nominal exchange rates are likely to be unique or
unsystematic rather than systematic, the unexpected changes
in the nominal exchange rates should be diversified away by
the investors' holding the well-diversified portfolios in
terms of the multiple foreign currencies, because the project
evaluation is for the investors, but not directly for the
1 See
2 See
Shapiro[1989] for a discussion on the inflation risks.
Dufey and Giddy[1978] and Shapiro[1989] for a detailed
discussion on the uses of the market-based forecasts.
PAGE 143
firm.
Therefore, the FX risks associated with the unexpected
changes in the nominal exchange rates are irrelevant to the
project evaluation from the investors' perspectives.
However, from the firm's perspective, the unsystematic
FX risks are very important because, if the firm cannot hold
their own well-diversified portfolios in terms of the
multiple foreign currencies due to difficulties in
diversifying the firm's real assets, the firm is exposed to
the serious FX risks associated with the unexpected changes
in the nominal exchange rates, whereas investors are less or
almost not affected by the unique FX risks.
Because, at the
beginning of the chapter, the reducing the FX risks from the
firm's perspective is justified due to the imperfections, the
firm's position of being exposed to the FX risks attributable
to the unexpected changes in the nominal exchange rates would
be serious, causing negative impacts on the firm's value.
In
this connection, even though the unexpected changes in the
nominal exchange rates are irrelevant to the project
evaluation, the effects of the FX risks associated with the
unexpected changes in the nominal exchange rates will be
discussed.
In addition to the distinction between expected and
unexpected changes in the nominal exchange rates, the
contractual cash flows exposed to the FX risks are grouped
into three categories, these are, 1) financial contractual
cash flows, 2) operational contractual cash flows, and 3)
other contractual cash flows.
The financial contractual cash
PAGE 144
flows exposed to the FX risks are those cash flows explicitly
or implicitly bearing fixed interest rates such as borrowing
and lending in the international money markets, futures, and
forwards.
The operational contractual cash flows exposed to
the FX risks are, for example, outstanding and future sales
or purchase contracts, account receivables, account payables,
acquisitions of foreign assets incurring liabilities in
foreign currencies and so on.
Finally, the other contractual
cash flows exposed to the FX risks are those which cannot be
grouped in the former two categories, such as tax shields on
depreciation.
The FX exposures associated with the expected
and unexpected changes in the nominal exchange rates are
reviewed for the three types of contractual cash flows,
respectively.
First of all, the financial contractual cash flows
explicitly or implicitly bearing the interest rates are not
affected by the expected changes in the nominal exchange
rates because I assume that the interest rates already
reflect the expected changes.
However, the financial
contractual cash flows are subject to the effects of the
unexpected changes in the nominal exchange rates, which are
deviations from the expected equilibrium nominal exchange
rates based on the IFE.
And, if the FX risks caused by these
deviations are not diversified away, the financial
contractual cash flows should be discounted with additional
risk premiums appropriate for the FX risks.
PAGE 145
Secondly, the operational contractual cash flows are
affected by both the expected and unexpected changes.
However, some operational contractual cash flows are not
affected by the expected changes.
Those are contracts which
are settled in a relatively short period and priced in a
forward exchange rate of the settlement date (if the forward
rate is available), reflecting expected changes in the
nominal exchange rates. However, because of the price
rigidity in short-term and competitive business environments,
pricing products and services in forward rates might not be
possible unless the products and services are fully
differentiated from others.
Moreover, the long-term
contracts are hard to be priced in the market-expected longterm exchange rates.
These risks had better be grouped as
the FX risks on the non-contractual cash flows, and these are
sensitive to the changes in the real exchange rates rather
than those in the nominal exchange rates.
discussed in next section.
This will be
On the other hand, the unexpected
changes in the nominal exchange rates fully affects the
operational contractual cash flows in the same manners as the
financial contractual cash flows are affected by the
unexpected changes in the nominal exchange rates.
Thus, the
risk premiums might be necessary to evaluate the operational
cash flows if those FX risks are not diversified away.
Finally, the other contractual cash flows are affected
by both the expected and unexpected changes in the nominal
exchange rates.
For instance, the tax shields on
PAGE 146
depreciation is affected by both expected and unexpected
changes because these cash flows are fixed completely
irrelevant to the foreign exchange rates and because the FX
risks are not generally hedged in these cases partly due to
uncertainty in applicability of tax shields.
In conclusion,
1) the FX risks on the contractual cash flows are those
associated with the expected changes in the nominal
exchange rates only because the FX risks associated
with the unexpected changes in the nominal exchange
rates are irrelevant to the project evaluation from
investors' perspective and because the FX risks
attributable to the changes in the real exchange
rates have minor effects on the contractual cash
flows; and
2) the FX risks, associated with the expected changes
in the nominal exchange rates, on the contractual
cash flows are chiefly caused by the unmatched cash
flows denominated in multiple currencies with regard
to the foreign currency transactions.
The following TABLE-14 summarizes the FX exposures of the
contractual cash flows relevant to the project evaluation.
PAGE 147
TABLE-14: FX Exposures of Contractual Cash Flows
expected changes in
nominal exchange rates
types of
cash flows
financial contractual
NO
operational contractual
YES
other contractual
YES
1.2.
FOREIGN EXCHANGE EXPOSURE ON NON-CONTRACTUAL CASH FLOWS
The FX exposures on non-contractual cash flows are
sensitive
to the real exchange rates and to the nominal
exchange rates.
Differences of the effects of the real and
nominal exchange rates on the non-contractual cash flows are
that the changes in the real exchange rates fully affect
expected cash flows in foreign currencies by affecting the
competitive environments and the project's cash flow
structures, whereas the nominal exchange rates affect the
non-contractual cash flows primarily in terms of the foreign
exchange transactions.
Therefore, it is generally recognized
that the real exchange rates are main factors affecting the
non-contractual cash flows.
In this section, like the contractual cash flows, noncontractual cash flows are grouped into the same three groups
as those of the contractual cash flows.
The financial non-
contractual cash flows are those which are not fixed in
nominal terms, but claims and liabilities are determined by
PAGE 148
contracts in variable terms, such as borrowing & lending with
floating interest rates. The operational non-contractual cash
flows are those associated with the primary operations, such
as purchases of input sources and sales of products and
services without any contractual commitment.
The other non-
contractual cash flows are those irrelevant to the financial
and operational non-contractual cash flows, such as intracompany cash flow transfers.
The FX risks associated with
the real nominal exchange rates are discussed in terms of
three different types of non-contractual cash flows.
First of all, the financial non-contractual cash flows,
such as floating rate borrowings and lendings, are affected
if the outstanding interest rates, which are tied to certain
interest rates in the market, are not offset by the realized
changes in the nominal exchange rates.
An actual effect is
that, with the floating interest rates, the risks of interest
rates fluctuations are shifted from lenders to borrowers.
Therefore, from the standpoint of the borrowers, the floating
exchange rate borrowing and lending are affected by the
deviations of the realized nominal exchange rates from the
equilibrium nominal exchange rates determined by the IFE.
That is the unexpected changes in the real exchange rates
rather than the changes in the nominal exchange rates.
In
this sense, the financial non-contractual cash flows are
affected only by the unexpected changes in the real exchange
rates, which are irrelevant to the project evaluation.
~
PAGE 149
Secondly, the operational non-contractual cash flows are
affected by the changes in the nominal exchange rates and by
the
changes in the real exchange rates.
The effects of the
expected and unexpected changes in the nominal exchange rates
on the operational non-contractual cash flows are similar to
those on the operational contractual cash flows in terms of
the foreign exchange transactions because, even in the noncontractual transactions, the timings of the cash inflows and
outflows for the non-contractual purchases and sales
generally have time-lags.
In this sense, the FX risks,
associated with the changes in the nominal exchange rates, on
the non-contractual operational cash flows are of the same
nature as that for the contractual operational cash flows.
In addition to the FX risks associated with the changes in
the nominal exchange rates, the changes in the real exchange
rates more seriously affect the operational non-contractual
cash flows in a sense that they affect the expected cash
flows denominated in foreign currencies.
This is because the
changes in the real exchange rates imply the changes in the
relative prices among countries or even within a country,
which cause the "competitive effects" on the operational noncontractual cash flows by changing the firm's competitive
position, and sources and costs of inputs. 1
The determinants
of this FX risks are the market structure where the firms
1See Shapiro[1984] for a discussion on the linkage between
currency risks, represented by inflation risk and exchange
rate changes, and relative price risk.
PAGE 150
compete and the market structure where the firms source the
inputs.1
Finally, the other non-contractual cash flows are
primarily affected by the changes in the nominal exchange
rates in terms of foreign exchange transactions, and secondly
the changes in the real exchange rates because the amounts of
the other non-contractual cash flows, such as intra-company
cash transfers, are determined by over-all regulations and
cash flows positions of the firm.
In conclusion,
1) the FX risks on the non-contractual cash flows are
those associated with 1) the expected changes in the
real exchange rates and 2) the expected changes in
the nominal exchange rates; and
2) the FX risks, associated with the expected changes
in the real exchange rates, on the non-contractual
cash flows are chiefly caused by the relative price
changes among the countries; and
3) the FX risks, associated with the expected changes
in the nominal exchange rates, on the noncontractual cash flows are caused by the unmatched
cash flows denominated in multiple currencies with
regard to the foreign currency transactions.
1 For
more detailed discussions on the determinants of the
"competitive effects", see Flood and Lessard[1986].
Also,
similar discussions are made by Shapiro[1989].
~
PAGE 151
The following TABLE-15 summarizes the FX exposures of the
non-contractual cash flows relevant to the project
evaluation.
TABLE-15: FX Exposures of Non-Contractual Cash Flows
expected changes in
real exchange rates
types
expected changes in
nominal exchange rates
financial
NO
NO
operational
YES
YES
other
YES
YES
PAGE 152
2.
REVIEW FOR HEDGING FOREIGN EXCHANGE EXPOSURES
This section reviews concepts of the FX exposure
management based on the reviews on the FX exposures in the
last section.
This review is essential to conceptually
incorporate the FX exposures into investment analysis so as
to obtain the FX exposure-adjusted values of projects.
This
enables analyst and decision-makers 1) to compare individual
projects on the same basis of risk-return trade-off and 2) to
identify the FX risks of projects under consideration and the
sensitivities of the projects to the nominal and real
exchange rate volatility.
Before getting into the reviews, it would be necessary
to consider the difference of the FX risk diversification and
the FX risk hedging in order to clarify the implications of
the FX hedgings.
The FX risk diversification is to diversify
away the unsystematic risks of the FX risks, fully depending
on the negative or not-perfect correlations between the
currencies denominating the asset and liabilities.
Due to
the FX risk diversification, investors could be indifferent
to the unsystematic FX risks, in theory.
On the other hand,
the FX hedging is to reduce unmatched amounts of foreign
currencies or to generate offsetting cash flows so as to
minimize uncertainty of the net cash flow positions.
Thus,
since the FX hedging is not fully relying on the
correlations, it is a more positive measure to reduce both
the systematic and unsystematic FX risks simultaneously.
PAGE 153
Therefore, it is sometimes difficult to distinguish the
hedgings of the unsystematic FX risks from the hedgings of
the systematic FX risks.
Discussed in this section is the FX
hedging.
This section tries to discuss, but not decisively
describe how to estimate costs of hedging or reducing the FX
exposures, though it is one of the most difficult tasks in
the FX exposure management once the FX risks are identified
and the ways of hedging or reducing the FX risks are
determined, subject to the costs of hedging.
Because
estimating costs of hedging or reducing the FX exposures
depends on the project-specific factors, only the conceptual
FX risks management methods are reviewed.
First, concepts of operational hedgings, and second,
concepts of financial hedgings are reviewed.
2.1.
OPERATIONAL HEDGING 1
The operational hedging is chiefly 1) to hedge the longterm FX risks caused by the relative price changes among
countries, which are generally considered to be most serious
FX risks for international projects, and 2) to hedge the FX
risks caused by the unmatched foreign currency cash flows.
Therefore, it corresponds to the FX risks, associated with
the changes in the real exchange rates, on the operational
1 The
contents of this section is cited mainly from Cornell
and Shapiro[1983] and Shapiro[1989].
--
I
I
PAGE 154
non-contractual cash flows, and to the FX risks,associated
with changes in the nominal exchange rates in terms of the
foreign currency transactions.
Therefore, at first, the
concepts of the operational hedging are reviewed based on the
determinants of the FX risks on the operational noncontractual cash flows discussed before, and secondly, based
on the foreign currency transactions.
At first, the determinants of the FX risks caused by the
changes in the real exchange rates are 1) the market
structure to compete in and 2) the market structure to source
in.
Consequently, these determinants correspond to 1)
marketing and strategic management and 2) production and
operation management, respectively. The marketing and
strategic management of the FX exposures is quoted from
Cornell and Shapiro[1983] and Shapiro[1989] as follows.
1) Market Selection and Market Segmentation
By adjusting the market mix to compete in, both in
country-by-country and in segment-by-segment basis,
firms mitigate the impacts of changes in real
exchange rates on revenues so as to stabilize or
maximize long-term profits.
2) Pricing Strategy
By adjusting prices of products and services, firms
keep themselves in equilibrium points where marginal
revenues equal marginal costs in order to maximize
profits.
However, degrees and frequencies of the
adjustment of the prices are subject to the trade-
PAGE 155
offs between profit margins and market shares,
likelihoods of persistence of the changes in the
real exchange rates, consumers' price sensitivities
and etc.
3)
Promotional Strategy
By allocating promotional activities among the
markets to compete in, subject to the promotional
budget constraints, firms maximize profit margins.
4) Product Strategy
By adjusting timings of introductions of new products
or deletions of obsolete products, firms mitigate
negative impacts of changes in relative prices on the
introduction or deletions of the products.
Secondly, the production and operation management of the
FX exposures is quoted from Cornell and Shapiro[1983] and
Shapiro[1989]
as follows.
1) Input Mix
By substituting domestic(imported) inputs for
imported(domestic) products, depending on the
relative prices and degrees of substitution
possibilities, firms achieve minimum input cost
structures so as to mitigate or exploit impacts of
changes in relative prices.
2) Shifting Production among Plants and Plant Location
By shifting production among countries or
reallocating plants worldwide, firms achieve minimum
cost structures.
PAGE 156
These operational hedging methods are important and
effective in competitive and changing market environments,
and these are, in practice, more dynamic processes, due to
changing environments in the sourcing and sales markets, than
the financial hedging which can
achieve almost perfect
hedging once locked in. Therefore, the hedging the FX risks,
associated with the changes in the real exchange rates, of
the operational non-contractual cash flows is a very
difficult task.
The second chief objective of the operational hedging is
to minimize or eliminate the FX risks caused by unmatched
amount of the cash flows in the multiple foreign currencies
at each point of time.
Since this objective is directly
affected by the first objective of the operational hedging,
that is, hedging the long-term FX risks attributable to the
relative price changes among countries, the operational
hedging becomes a more complicated task of trying to optimize
the input and output structure of the project, in the longrun and in the short-run.
The conceptual procedure of minimizing or eliminating
the unmatched amount of the cash flows in the multiple
foreign currencies at each point of time is explained with a
matrix of the cash flows in the multiple currencies as
follows:
PAGE 157
MATRIX OF MULTIPLE CASH FLOWS at time=t
= [ Ct,i,j ]
Ct, 1,1
Ct,1,2 ....................................
Ct,2,1 Ct,2,2
....................................
Ct,3,1 Ct,3,2 ....................................
:
:
....................................
S....................................
Ct,m, 1 Ct,m,2 ....................................
Ct,l, n
Ct,2,nl
"m" = number
of relevant
Ct,3,nl
I mu lt ip le
:
currencies
Ct,m, n l
"n"= number of cash flow categories
of the same risk class
where Ct,i,j denotes a cash flow at time=t of cash
flow risk class "i"th denominated in
"j"th currency;
m denotes a number of relevant multiple
currencies; and
n denotes a number of cash flow categories
of the same risk class.
The column of the above matrix represents a series of
the multiple currency cash flows of the same risk class at
time=t, and the row represents a series of the multiple riskclass cash flows in one currency at time=t.
The process of
operational hedging to eliminate or minimize the unmatched
cash flows in the multiple currencies is identical to
reducing or nullifying wide dispersion of the multiple
currency cash flows in various risk classes in the cash flow
matrix.
For instance, if the project has a large amount of
liabilities due to the purchase of the input sources in the
"i"th currency and claims due to the sales of the products in
the "j"th currency, both liabilities and claims are exposed
i_
PAGE 158
to the FX risks.
Simply, by purchasing the input sources in
the "j"th currency or by selling the products and services in
the "i"th currency, for instance, the amount exposed to the
FX risks could be reduced, assuming that 1) such operational
arrangements are possible, and 2) the liabilities and claims
belong to the same risk class.
However, between the different risk classes, the tradeoffs of the liabilities and claims could be arranged,
requiring more complex evaluation of the risks involved in
such arrangements.
For instance, accumulated account
receivables could be sold so as to minimize debt principles,
although the risk classes of both cash flows are different.
This sort of arrangement requires risk-return trade-offs
between the parties concerned.
In conclusion, the operational hedging is a dynamic and
project-specific process of hedging the FX risks associated
with the relative price changes among the countries, and the
unmatched amount of cash flows at each point of time.
2.2.
FINANCIAL HEDGING
The financial hedging is primarily to hedge the shortterm FX risks associated with the expected changes in the
nominal exchange rates.
The long-term FX risks associated
with the expected changes in the nominal exchange rates could
be hedged by the financial instruments, but they tend to
PAGE 159
require more costly arrangements than the short-term
financial instruments.
Whereas the operational hedging of the FX risks
associated with the expected changes in the nominal exchange
rates are efforts of reducing or eliminating the unmatched
amount of the multiple-currency cash flows, the financial
hedgings of the FX risks generates a set of financial cash
flows or swap the cash flows to offset the unmatched foreign
currency cash flows with the financial arrangements, leaving
the unmatched amount of the multiple-currency as they are.
Therefore, the financial hedging generally requires funds at
hand or in future due dates to fulfill the financial
contracts.
Therefore, the financial hedgings for the non-
contractual cash flows tend to be for the short-term because
the cash flows exposed to the long-term FX risks are less
certain than those exposed to the short-term FX risks.
Of
course, the financial hedgings for the contractual cash flows
can be either for long-term or for short-term, depending on
the durations of the contracts.
The major financial hedging widely used or recently
innovated are such as future exchanges, forward exchanges,
foreign exchange options, currency swaps, back-toback/parallel loans, credit swaps and so forth. 1
The three
financial hedging instruments -- futures, forwards, and
options -- are briefly reviewed below.
1See Eiteman and Stonehill[1989]
financial hedging.
for an overview of the
PAGE 160
The futures are obligations to buy or sell the foreign
currency for the future price at the designated future date.
Because 1) the futures are traded in standardized amounts on
the organized exchanges, and 2) the futures are marked-tomarket (Gains or losses in each period due to the difference
between the future prices in different periods of time
generates cash flows during the contracted periods.), costs
of hedging the FX risks with the futures tend to be expensive
and sometimes the futures do not satisfy project-specific
requirements for hedgings, such as amounts and timing to be
hedged.
On the other hand, the forward exchange contracts are
obligations to buy or sell foreign currency for the forward
price at the designated future date, but can be tailor-made
with regard to the amounts, the forward price, and the timing
of the hedging.
Since, on the delivery date only, the
contracts are settled, the forwards can perfectly lock in a
certain net cash flow position, whereas the futures cannot
due to the transactions during the contract periods.
However, since the forwards are obligations, the amount
required to fulfill the contracts must be prepared on the
delivery dates.
Otherwise, the forwards create uncovered
short positions.
Different from the futures and forwards, the foreign
exchange options are contingent claims whose payoffs are
dependent on
the
future values
of
the
underlying
assets.
on
the
future
values
of
the
underlying
assets.
dependent
this sense,
sense, thethe options
options cannot
cannot perfectly
perfectly lock
lock inin aa certain
certain
this
-4
------ --------- ---
In
In
PAGE 161
net cash position, but, the options adequate to hedge the
exposed positions can generate the more valuable cash
positions by keeping the losses at the designated minimum
levels.
In other words, the options can transfer the
variabilities of the foreign exchanges to other participants
in the option markets, resulting in changes in the
probability distributions of the future payoffs.
Moreover,
since the options are not obligations, but the right to buy
or sell foreign currencies, short positions incurred in case
of the futures and forwards would not occur in theory.
However, there are some limitations on practical uses of
the financial hedging instruments.
First, since these
financial hedging instruments are accompanied by hedging
costs, such as transaction costs, brokers' fees, costs of
options and etc, these instruments are not generally used for
daily and small foreign currency transactions, but rather
used for large amount of unmatched cash flows whose FX risks
are expected to significantly affect the project values.
Secondly, since the foreign exchanges and even the expected
cash flows in multiple currencies are substantially volatile,
the hedging strategies should be adjusted to match the hedge
ratios at each time the volatilities changes.
Thus, it
requires continuous changes in the hedging position in order
to achieve perfect hedgings.
This might not be realistic.
For these reasons, from the viewpoint of evaluating projects,
it might be enough to incorporate the hedging costs of the
crucial foreign cash flows only.
_I
L
PAGE 162
Then, a question is how to estimate the costs of the
financial hedgings in order to incorporate the costs into the
expected cash flows in the V.C. formula.
The transaction
costs of the futures and the forwards might be estimated
according to the historical data on the transaction costs.
However, since the futures and the forwards traded or quoted
in well-organized markets provide primarily the short-term
futures and forwards, estimating the future prices and
forward prices in the near future could be done with small
range of errors, whereas the long-term future and forward
prices are almost impossible to estimate.
This might be one
of reasons why the long-term futures and forwards are not
traded in large volumes.
Therefore, the future and forwards
can be used to hedge the FX risks occurring in early years of
the project.
These FX risks are those associated with the
borrowing, the capital expenditures and other large cash
flows in the beginning of the project.
On the other hand,
the option prices can be theoretically estimated by using the
Black-Scholes formula described in chapter 2.
The Black-
Scholes formula calculates the present value of the European
call options. 1
The present value of the European put option
can be calculated by using the following option parity
formula:
Value of Put = Value of Call - Value of Share
1 See Brealey and Myers[1988]
currency option.
·-'~ · ~
for sample calculation of the
PAGE 163
+ Present Value of Exercise Price
However, similar to the futures and forwards, the long-term
options are not generally traded in the option markets
probably because the option values are too large to be traded
since the option values substantially increase as the time to
maturity of the options increase.
Therefore, applying the
Black Scholes formula to the long-term options might not be
realistic.
The other difficulty in estimating the costs of the
financial hedgings in evaluating projects is to determine
when to buy the futures, forwards, and options because the
purchase timing affects the future and forward prices, option
prices.
Thus, incorporating the effects of the financial
hedgings is, first, to identify significant unmatched amounts
exposed to the FX risks, second, to think of possibilities of
the operational hedgings, third, if it is impossible, to
select the financial hedging instruments, and to estimate the
effects of the hedging, and finally, to incorporate the
effects into the forecasted cash flows.
What are theoretical implications to the operational and
other cash flows if these financial hedgings are perfectly
applied to them,assuming there exists no impediment in
applicability?
It means that the operational and other cash
flows, which are hedged with the financial hedging
r
PAGE 164
instruments, become equivalent to the financial cash flows in
a sense that they are not affected by the expected changes in
the nominal exchange rates, although costs of the financial
hedging must be taken into considerations.
As a result, the FX risks associated with the expected
changes in the nominal exchange rates can be almost perfectly
hedged by the financial instruments, though the applicability
of the financial hedging depends on the certainty of the
funds to fulfill the financial arrangements.
2.3.
CONCLUSION
As the following Table summarizes the discussions on the
FX risks exposures and hedgings, the FX risks which should be
examined in evaluating international projects consists of two
FX risks:
1) the FX risks associated with the unmatched
amounts of multiple currency cash flows, caused by the
changes in the nominal exchange rates, and 2) the FX risks
associated with the relative price changes among countries,
caused by the changes in the real exchange rates.
In order
to hedge those FX risks, two hedging strategies should be
considered and incorporated in the evaluation of
international projects, these are, 1) the operational hedging
which is primarily for the long-term FX risks associated with
the relative price changes among countries, and secondly for
the long-term FX risks attributable to the unmatched amounts
of multiple-currency cash flows, and 2) the financial hedging
PAGE 165
which is for the short-term and long-term FX risks associated
with the unmatched amounts of multiple-currency cash flows.
Table 16: FX Risk Exposures and Hedgings
FX Risk Exposures
category of
exposure
lunmatched amounts of
Iforeign cash flows
Irelative price changes
lamong countries
causes of
exposure
Ichanges in
Ichanges in
Inominal exchange rates Ireal exchange rates
----------------------------------------
Operational
Hedging
Ireduce or eliminate
ladjust structures of
Iunmatched amounts
Icosts and sales market
lin multiple currencies
Ilong-term,
Financial
Hedging
(short-term) I long-term
Igenerate a set of cash I
iflows or swap cash flowi
Ito offset the unmatchedI
Iamounts
Ishort-term, (long-term)I
In next section, the above mentioned FX risks will be
conceptually incorporated in a general formula of the V.C.
methodology.
i;
I
r
r
i
H
t
i
PAGE 166
3.
VC FORMULA INCORPORATING FOREIGN EXCHANGE EXPOSURE
A final objective of this section is to propose a
general formula of the V.C. methodology, which conceptually
The
incorporates the Foreign Exchange exposures and hedging.
proposed general formula is a derivative from the general
formula proposed by Lessard and incorporates the FX risks
cash flow components and associated risk premiums based on
the reviews of the FX exposures in the previous two sections.
In the following sub-sections, first, a general formula
of the V.C. methodology will be presented by using the cash
flow matrix which was discussed earlier, and second, three
cash flow matrices will be discussed in relation to the FX
hedging.
3.1.
GENERAL FORMULA OF V.C. METHODOLOGY
A general formula of the V.C. methodology, which
conceptually incorporates the FX exposures and hedgings, is
proposed as follows by using the cash flow matrix:
Valuation by Components
k
Y= 9t * Ct * Dt * T
(31)
t=o
where Bt denotes a market-expected nominal exchange rate
vector for all relevant currencies at time=t;
denotes an after-FX-hedging-adjusted expected
@t
cash flow matrix for all cash flow components
PAGE 167
of the same risk-class in each relevant
currency at time=t;
Bt denotes a systematic-risk discount factor
matrix for all cash flow components of the
same risk-class at time=t in home currency
terms: and
9 denotes a unit vector whose each element is
one.
Thus, the V.C. is expressed as a summation of the
products of four matrices from time=0 to time=k (ending time
of the project).
The product of
Rt and Ct
is a one by "n"
vector which represents after-FX-hedging-adjusted expected
cash flows in each cash flow component in each risk-class at
time=t in terms of the home currency.
Ct ,
and Dt
The product of
2t ,
represents a one by "n" vector which represents
discounted values of the after-FX-hedging-adjusted expected
cash flows in each cash flow component in each risk-class at
time=t in terms of the home currency.
Then, the product of
9t, Ct, Dt, and T represents a summation of the discounted
values of the after-FX-hedging-adjusted expected cash flows
in each cash flow component in each risk-class at time=t in
terms of the home currency.
Finally, the discounted values
of each time are summed up.
The formats of each matrix is as
follows.
1) Market-Expected Nominal Exchange Rate Vector
( i=l ~ m )
= [ Et, l ,Et,2 ........................... ,Et,m
t = [ Et,i ]
]
(1, m): 2t
PAGE 168
denotes a market-expected nominal
exchange rate of currency "i" over
the home currency at time=t; and
"m" denotes a number of relevant currencies
including the home currency.
where Et,i
The market-expected nominal exchange rate implies the
nominal exchange rate implicitly determined by the
term-structure of interests of the relevant two
countries according to the IFE.
2) After-FX-Hedging-Adjusted Expected Cash Flow Matrix
(m, n) : @t
@t =
[ Ct,i,j
= I Ct,l, 1
I Ct,2,1
I
I Ct,m, 1
]
( i=l ~ m ;
j=1 ~ n )
Ct,1,2 ...........................
Ct,l,n I
Ct,2,2 ...........................
Ct,2,n I
:
...........................
Ct,m,2 ...........................
I
Ct,m,n
I
where Ct,i,j denotes a after-FX-hedging-adjusted
expected amount of a cash flow
component "j"
denominated in
currency "i" at time=t ;
"m" denotes a number of relevant currencies
including the home currency; and
"n" denotes a number of project cash flow
components plus one which is used for
the cash flows associated with the
financial FX hedging.
For simplicity, the first
row is allocated to
the home currency cash flows, and the last
column "n" is allocated for the cash flows
associated with the Financial FX hedging.
3) Discount Factor Matrix ( n, n ) : Bt
Pt =
=
[ Dt,i,j
Dt , ,
S
0
I
i
0
( i=1 - n ;
]
1
0
...........................
Dt,2,2 ...........................
0
...........................
0
...........................
j=l ~ n )
0
O
Dt,n,n
II
I
PAGE 169
where Dt,i,i denotes a systematic discount factor
of a cash flow component "i"
denominated in home currency at
time=t;
Dt,i,j
( i # j ) equals zero (0);
"n" denotes a number of project cash flow
components plus one which is used for
the cash flows associated with the
financial FX hedging.
The discount factor is determined by the CAPM
discussed earlier, which simply reflect the
systematic business risks in the Home Currency
Terms. The relationship with the discount rate in
the general formula by Lessard is as follows.
t
= 1 / H(1+-i)
Dt,i,i
i=l
where ni denotes a discount rate for period
from time=t-1 to time=t.
4) Unit Vector
( 1, m )
:
( i=1 ~ n)
= [ Ti ]
1 ]
1 ...........................
= [ 1
where Ti
"n"
"i"; and
equals one (1) for all
denotes a number of project cash flow
components plus one which is used for
the cash flows associated with the
financial FX hedging.
The general formula above presented is exactly identical
to that by Lessard.
The difference will be discussed in next
sub-section.
3.2.
AFTER-FX-HEDGING-ADJUSTED CASH FLOW MATRIX
The after-FX-hedging-adjusted cash flow matrix comprises
three sub-matrices, a cash flow sub-matrix without FX
PAGE 170
hedging, an operational hedging cash flow sub-matrix, and a
financial hedging cash flow sub-matrix.
sub-matrix are "m" by "n"
in
Dimensions of each
order to keep the additivity of
the matrices.
First, the cash flow sub-matrix without FX hedging
implies the multiple-currency cash flows forecasted in each
cash flow components at each time without explicitly
considering the FX hedging.
The columns of the matrix
represent categories of the cash flow components in each
risk-class.
Here, the cash flow category by Lessard ,
in Chapter 1 as a formula (5),
shown
is applied to each column in
the matrix as follows because the category is considered to
I
be representative in almost all cases:
I) nr
operating
dedent
flows: on firm's oveatax
and
1) non-contractual operating flows:
COLUMN 1: capital outlay,
COLUMN 2: remittable after-tax operating cash flows,
2) contractual flows:
COLUMN 3: contractual operating flows,
COLUMN 4: depreciation tax shield,
COLUMN 5: tax shield due to normal borrowing,
COLUMN
6: financial subsidies or penalties,
3) operating flows dependent on firm's overall tax and
cash-flow position
COLUMN 7: tax reduction or deferral via
interaffiliate transfer,
COLUMN 8: additional remittances via interaffiliate
transfers,
4) financial hedging
9: cash flows generated by the financial
COLUMN
transaction
including expected
hedging
unmatched
amounts of
multiple-currencies
as discussed
•otatalfo
2)
costs
iOUM ,,cnrcta
column
The
Tne
column "9"
"~"
prtigfo
in
is
is a
a newly
newly added
adaea
In order
oraer to
to represent
represent cash
casn
the
flows
flows generated
generated by
by the
the financial
financial hedging
hedging so
so as
as to
to offset
offset
the
unmatched amounts of multiple-currencies
i
as discussed
PAGE 171
Each row is allotted for each relevant currency,
earlier.
setting the first row for the home currency.
Thus, the cash
flow matrix without FX hedging ( &t) is as follows:
Et
= [ Xt,i,
=
j
Xt,l,
I Xt,2,1
I
:
I Xt,m,1
( i=l ~ m ; j=l ~ 9 )
]
Xt,1,2 ...........................
Xt,2,2 ...........................
Xt,1,9 I -- > HC
Xt,2,9 I -- > FC 2
Xt,m,2 ...........................
Xt,m,9 I -- > FC m
A
A
COL(1)
I
...........................
COL(2)
I
A
COL(9)
I
cash flow components
where Xt,i,j denotes an expected amount of a cash
flow component "j" denominated in
currency "i" at time=t; and
"m" denotes a number of relevant currencies
including the home currency.
Therefore, the discounted value of this matrix, as is similar
to the formula
(31), is the discounted value of the project
without FX hedging.
Discounted Value of the project without FX hedging
k
-= I t * Xt * Dt * T
(32)
t=O
The users would easily identify which cash flows are exposed
to the FX risks associated with the unmatched amounts of
i
I
PAGE 172
multiple-currency cash flows by summing up each cash flows in
each row (currency).
If any sum of each row except for the
first row (home currency) is not equal to zero(0), these
foreign currencies are exposed to the FX risks.
In addition
associated
to identifying
identifying the
the FX
FX risks
risks
associated with
with the
the unmatched
unmatched
amounts of multiple-currency
multiple-currency cash flows,
flows, the FX risks
risks
price
associated
associated with
with the
the relative
relative
price changes
changes among
among countries
countries
hedging
Then,
should
should be
be identified.
identified.
Then, the
the operational
operational FX
FX risk
risk
hedging
the operational
will
be
will
be implemented
implemented by
by generating
generating the
operational hedging
hedging
cash flow matrix.
matrix.
cash flow
flow matrix
matrix implies
Second, the
the operational
operational hedging cash
Second,
implies
in
cash flows
flows forecasted
forecasted in
the changes
changes in
in multiple-currency
multiple-currency cash
the
each cash
cash flow
flow components
components at
at each
each time
time by
by explicitly
explicitly
each
considering the
the operational
operational FX
FX hedging.
hedging.
considering
The format
format of
of the
the
The
matrix is
is exactly
exactly the
the same
same as
as that
that of
of the
the cash
cash flow
without
matrix
flow without
FX hedging.
hedging.
FX
Thus, the
the operational
operational hedging cash
cash flow
flow matrix
Thus,
(Nt)
is as
follows:
(~t)
is
as follows:
=
t =
~i~t
=
Yt,i,j i
[[ Ytij
(( i=l
i=l ~ m
m ; j=l
j=l ~ 9
9 ))
Yt,
Yt, i, , 1
1
I Yt,
Yt, 2,1
2,1
Yt,1,2 ...........................
Yt,1,2
···························
Yt,2,2
Yt,2,2 ...........................
···························
Yt,
Yt, 1,9
i, 9
Yt,2, 99
Yt,2,
I Ytml
Yt,m, 1
Yt,m, 2
Ytm,2
Yt,m, 99
Yt.~,
...........................
where
Yt,i,j denotes
denotes an
an expected
expected changes
changes in
in
where Ytij
expected cash
cash flow
flow component
component "j"
"j"
expected
denominated in
in currency
currency "i"
"i" at
at
denominated
time=t by
by operational
operational hedging;
hedging; and
and
time=t
"m" denotes aa number of relevant currencies
currencies
"m"
including the
the home
home currency.
currency.
i
LCL~_
PAGE 173
Each cash flow element in the cash flow matrix without FX
hedging would be reduced, eliminated, or generated by the
operational hedgings in order to hedge the FX risks
associated with the changes in the nominal and real exchange
rates.
rar.es.
hedgings
operational
changes
by
the
of
the
amount
The
~ne
amoun~
or
·cne
cnanges
c>y
~ne
operailonil
neagings
matrix.
hedging matrix.
fill inin the
the operational
operational hedging
fill
Therefore, the
the
Therefore,
matrix
as
indicated
in
the
formula
formula
this matrix
as
indicated
in
the
discounted value
value ofof this
discounted
hedging.
the operational
operational FX
value ofof the
(31) isis the
the discounted
discounted value
FX
hedging.
(31)
operational
FX
hedging
Discounted Value
Value ofof the
the
operational
FX
hedging
kk
Y=
*
Yt ** DtDt *
~C 1•~t t
*
Yt
*
TT
Discounted
(33)
(33)
t=o
t=O
in
its
a firm,
which
is
in
a
long
position
For instance,
instance, if
if~a
firm,
which
is
in
a
long
position
in
its
For
from
the
switches
input
sources
liabilities,
local
currency
local
currency
liabilities,
switches
input
sources
from
the
of relatively
to
the
home
country
in
spite
host
country
host
country
to
the
home
country
in
spite
of
relatively
the
home
country
in
order
to
reduce
higher
price
levels
in
higher
price
levels
in
the
home
country
in
order
to
reduce
the
discounted
amount
of
the
local
liabilities,
unmatched
unmatched
amount
of
the
local
liabilities,
the
discounted
the
values
of
values
of
the
by
switching the
costs
generated
additional
additional
costs
generated
by
switching
the
the
present
values
of
the
operational
input
sources
are
input
sources
are
the
present
values
of
the
operational
hedaina
costs.
hedaina
costs.
hedging
costs.
However.
in
this
case.
the
FX
risks
still
However,
in
this
case,
the
FX
risks
still
However,
in
this
case,
the
FX
risks
still
remain
unless
the
unmatched amount
is
nullified.
remain
unless
the
unmatched
amount
is
nullified.
After
identifying
the
FX
risks
and
implementing
the
After
identifying
the
FX
risks
and
implementing
the
operational
FX
hedging,
it
would
be
almost
probable
that
some
operational
FX
hedging,
it
would
be
almost
probable
that
some
foreign
cash
flows
are
still
exposed
to
the FX
risks.
foreign
cash
flows
are
still
exposed
to
the
FX
risks.
the financial
financial hedging
hedging isis implemented.
implemented.
the
L,L~
Then,
Then,
PAGE 174
implies
matrix implies
cash flow
hedging cash
financial hedging
the financial
Third, the
flow
matrix
Third,
forecasted inin
flows forecasted
cash flows
multiple-currency cash
changes inin multiple-currency
the changes
the
associated with the financial hedgings at each time by
explicitly considering the financial FX hedging.
The format
cash
flow
of
the
that
same
as
exactly the
is
matrix
of the
riow
as
~na~
or
rne
casn
tne
same
tne
matrix
Is
exactly
Or
cash
flow.
hedging
operational
the
and
hedging
without FX
flow.
hedging
cash
the
operational
FX
hedging
and
without
matrix
flow
cash
hedging
financial
Thus, the
matrix
cash
flow
the
financial
hedging
Thus,
as
is
( Rt)
as
~t)
is
(
follows:
follows:
E3t
t
Zt,i,j
= [[ Ztrirj
=
| Ztll
Zt,l,l
Zt,2,1
I Zt,2,1
m,
I Zt,Zt,m,1
m,
1
i=1
(( i=l
]i
-
9 ))
m ; j=1
j=l
9
m
Zt,1,2 ...........................
· ···· ··· ··· ··· ··· ··· ··· ····
Zt,2,2 ·...........................
Zt,2,2
···· ··· ··· ··· ··· ··· ··· ·· ··
Zt,1,2
Z m, 2 ...........................
Zt,1,9
Zt,2,9
Zt,2,9
Zt,1,9
I
I
m, 9
Zt,m,99 I
...........................
Zt,m,2
m,
2
· ··· ··· ···· ··· ··· ··· ··· ·· ··
Ztm,
Zt,
changes in
expected
Yt,i,j denotes
denotes an
where Ytij
in
changes
expected
an
"j"
flow
component
expected cash
expected
cash
flow
component
"j"
at
currency "i"
denominated inin currency
at
denominated
"i"
hedging; and
and
time=t by
financial
time=t
by
financial
hedging;
currencies
relevant currencies
denotes aa number
number ofof relevant
"m" denotes
"m"
home currency.
currency.
the home
including the
including
where
the operational
operational hedging,
implementing the
after implementing
instance, if,if, after
For instance,
hedging,
For
currency
units inin currency
1000 units
outflow ofof 1000
cash outflow
remains aa cash
there
still remains
there
still
"2", the
the financial
financial hedging
is implemented,
implemented, such
such asas aa forward
forward
is
hedging
"2",
"2" in
currency "2"
units ofof currency
1000 units
buying 1000
contract ofof buying
exchange contract
in
exchange
not yet
yet
"3", which
which isis not
currency "3",
units ofof currency
2000 units
for 2000
exchange for
exchange
major currency.
currency.
third major
the third
hedaed, throuah
the
through
hedged,
This transaction
transaction
This
financial
the financial
flows ofof the
cash flows
the financial
financial cash
only the
affects only
affects
"2"
row "2"
the row
(9) ofof the
column (9)
the column
matrix, inin the
flow matrix,
cash flow
hedging cash
hedging
i
~r~ll
i,i L"4~
_
PAGE 175
by increasing 1000 units in currency "112" and
and "3",
decreasing 2000 units in currency "3", whereas the other two
cash flow matrices do not change.
Also, the transaction
costs, in theory, should be added to the column
(9) in the
This procedure completes the
first row (home currency).
financial hedging matrix so that, in theory, all the expected
cash flows can be hedged, either by the operational or by the
financial instruments.
Thus, the discounted value of this
matrix, like the formula (31),
is the discounted value of the
financial FX hedging.
Discounted Value of the financial FX hedging
k
= X 9t * Zt * Dt * T
(33)
t=0
t
U
is:
formula
V.C.
general
the
proposed
In conclusion,
is:
V.C.
formula
proposed
general
conclusion,
the
In
Components
Valuation by
by
Components
k
= CX ~t9t ~* CtCt ~* f)tDt
t=O
t=0
Valuation
k
=
C
~t
t
*
*
(( ~tXt
+
+
Pt
* TT
(31)
(31)
-k
+ Zt
$t
+
T
) ** Dt
T
Bt
**
)
(31a)
(31a)
t=0
t=O
where Bt9t
where
@t
~t
Zt
?t
Rt
~t
rate vector
vector
exchange rate
expected exchange
denotes anan expected
(1,n) ;
(m,n);
matrix
cash
flow
expected
an
denotes
matrix
(mn);
cash
flow
denotes
an
expected
without
matrix
flow
cash
expected
an
denotes
without
cash
flow
matrix
an
expected
denotes
hedging;
FX
FX
hedging;
cash
flow
hedging
operational
denotes an
flow
hedging
cash
operational
denotes
an
matrix
(m.n);
matrix
(m.n);
matrix
flow
cash
hedging
financial
a
matrix
cash
flow
denotes
a
financial
hedging
denotes
denotes
PAGE 176
(m,n);
Bt denotes a discount factor matrix (n,n): and
I
denotes a unit vector (l,m).
The advantage of this "matrix-type" V.C. formula is:
1) it is easy to identify the FX risks because the cash
flow elements are individually shown in the matrix,
classified by the cash flow risk-class and the
currency;
2) it is easy to implement and check the FX hedging
because the changes in the cash flow elements by the
operational and financial hedging are separately
shown in each matrix;
3) it is easy to calculate the operational and financial
hedging values
(costs), by using the hedge matrix;
4) the matrix formula is easily built in any type of
computer programs so that users can create their own
evaluation model programs; and
5) by modelling the cash flow matrix, the sensitivity
analysis is easily implemented for various factors.
In next chapter, a real case project will be examined by
using the real discount rates calculated in Chapter 2 and the
concepts of the FX hedging reviewed in this chapter.
CHAPTER 5: CASE STUDY ON
INTERNATIONAL REAL ESTATE DEVELOPMENT PROJECT
IN THE UNITED STATES
PAGE 178
0.
INTRODUCTION
This chapter analyzes a real estate redevelopment
project actually undertaken in one of the major cities in
California, by applying the V.C. methodology to the case
project.
The case project, which can be considered to be an
" international project" because of the participation of the
foreign capital partner and the financing from foreign
sources, is analyzed 1) in terms of the risk and return
trade-offs among the project participants and 2) in terms of
the specific issues and sensitivities of the major factors
influential to the value of the case project.
The first section of this chapter outlines the nature of
the case project, especially in terms of the project
organization, structure, and risk and return trade-offs among
the project participants.
Then, from methodological
viewpoints, we re-examine an original assessment of the case
project which was made by one of the leading U.S. accounting
firms so as to verify whether or not the original assessment
was adequate enough to lead the project participants into
making correct decisions on the project acceptance.
In the second section, the V.C. methodology is applied
to the case project from viewpoints of the managing and
capital partners.
The results of the V.C are discussed in
terms of the project feasibility and risk-return trade-offs
among the participants.
In addition, it discusses the
specific issues
in
the case
case project
in
details,
implementing
issues
in
the
project
in
details,
implementing
specific
..
.~4LSE-_
~~
PAGE 179
the sensitivity analyses of the major variables which would
seriously affect the project value.
Finally, conclusions for the case project are made.
PAGE 180
1.
PROJECT ORGANIZATION STRUCTURE AND ORIGINAL ASSESSMENT
OF THE CASE PROJECT
This chapter discusses, first, the outline of the case
project, focusing on the organizational structure of the
project which determines the risk and return trade-offs among
the project participants, and is a key to success of the case
project.
Especially, the capital partner's overall business
position is discussed in relation to the project
organization.
Secondly, the original assessment of the case
project, which is based on the Internal Rate of Return
(discussed in chapter 1),
is re-examined from the
methodological viewpoints, and the misleading results are
discussed by correcting the serious errors in the assessment.
1.1.
PROJECT ORGANIZATION STRUCTURE :
MANAGING PARTNER, CAPITAL PARTNER, AND LOCAL GOVERNMENT
1.1.1 BRIEF HISTORY OF CASE PROJECT
A brief history of the case project until the project
was initiated is as follows.
In the beginning of the 1980s ,
the redevelopment agency of the city in California asked, in
public, competition bids for redevelopment planning of one
block in the downtown in order to redevelop the waste block
and to vitalize the city's stagnant economy.
As the result
of the competitive bids, a local developer(henceforth,
PAGE 181
denoted Managing Partner Mr.A) with one of major financial
institutions in California won the Exclusive Negotiation
Agreement with the redevelopment agency.
The proposed
planning was a complex of a 500-room hotel and a high-rise
office building, which was attractive to the agency.
During the three times modifications on the proposals,
the financial institution, which initially agreed on
financing the project as a capital partner, retired from the
project.
In the meantime, Managing Partner Mr.A made Deposit
Development Agreement with the redevelopment agency, looking
for a candidate as a capital partner.
company(henceforth
A subsidiary
denoted Capital Partner B Corp.),
which
is fully owned by a Japan-based construction and engineering
firm and was looking for investment opportunities in the
United States, agreed with the partnership with the Managing
Partner Mr.A in 1985.
In this brief history, a question naturally occurs with
regard to why the U.S. financial institution which were
originally involved in the project gave up the project.
Although the Capital Partner was informed that it had been
because the financial institution had been worried about
their too heavy investment on real estate projects, the
question still remains, because, from the beginning, they
knew that this project be a real estate project.
The V.C.
evaluation will help find possible reasons in later section.
I
-
r
PAGE 182
1.1.2. GENERAL PARTNERSHIP
Both partners formed General Partnership for the project
execution by providing equities of $ 24 Million (Capital
Partner B Corp.) and $ 1 Million (Managing Partner),
respectively.
Out of the equity of the Managing Partner, the
Managing Partner's equity of $ 800 Thousand is, in fact, a
sunk cost which the Managing Partner spent by the time for
the project.
Therefore, the Managing Partner's equity
contribution relevant to the project evaluation is $ 200
Thousand.
The accounting profits generated in the General
Partnership are distributed to each partner with the ratio of
3 (to Capital Partner) to 1 (to Managing Partner), whereas
the accounting losses are distributed to each partner with
the ratio of 96 (to Capital Partner) to 4 (to Managing
Partner).
On the other hand, the excess cash flows
generated by the project are distributed to each partner with
the ratio of 3 (to Capital Partner) to 1 (to Managing
Partner).
Under the structure of the General Partnership, a
question occurs with regard to adequacy of risk and return
trade-offs between the Managing Partner and the Capital
Partner.
The question is how adequate the distribution
ratios of the accounting profits and losses in relation 1) to
the risks each partner bears in the project and 2) to the
equity contributions of each partner.
One of the most
important factors affecting the question is the overall
PAGE 183
financial positions of each partner because the income tax
imposed on each partner is determined not solely by the
project's accounting profits and losses, but by the overall
tax accounting positions of each partner.
For the question,
the V.C. methodology will help examine the real value of the
project to each partner in later section.
The financing scheme, when the original assessment was
done, was to replace a short-term construction loan with an
interest rate of 9.5% for a 20-year balloon loan with an
interest rate of 11% by getting a guarantee from the Capital
Partner's parent firm. However, in fact, the project was
financed with non-recourse project financing loan with
floating interest rate by a syndicate of U.S. and Japan's
leading banks.
This change in financing will be discussed in
later section.
1.1.3 REDEVELOPMENT AGENCY
The redevelopment agency of the city agreed to sell the
redevelopment site under consideration for $ 6 Million to the
General Partner, on the condition that the Capital Partner
provide advances for acquisition costs of the sites to the
agency up to $14.8 Million.
For the advances, the
redevelopment agency issues two promissory notes to the
General Partner.
The First Promissory Note is in an amount
not to exceed the Purchase Price of $ 6 Million and bearing
·1_1
PAGE 184
interest at the rate of ten percent (10%) per annual, simple
interest.
The Second Promissory Note is in the amount of the
Capital Partner's advance of the Acquisition Costs in excess
of the Purchase Price and bearing interest at the rate of
twelve percent (12%) per annual, simple interest.
The
principal and interest of the Second Promissory Note is
payable from the Tax Increments (property tax) from the
site.(TAX INCREMENTAL FINANCING)
One of the advantages of this public financing method is
that, by adopting a profitable project whose appraisal value
would be expected to increase, the local government can
expect the real property tax to increase enough to finance
the acquisition and clearance of the site.
In turn, private
developers can purchase sites in relatively low prices
because the local government expects to retain enough
financing sources.
Therefore, profitabilities of projects
are key players in TIF.
However, if the actual profitability were substantially
lower than the expected profitability, The TIF would hurt
both developers and the local government, depending on how
the real property is appraised.
In this case, if the real
property appraisal well reflects the future value of the real
property, the expected real property tax would be
substantially less than the local government expected,
assuming the real property tax is unchanged, while the
developers would be seriously affected solely by the lower
profitability.
However, because the local government can
~··
PAGE 185
change the real property tax rate, and the real property
appraisal, which the local government generally requests real
property appraisers to assess, might be distorted.
Thus,
under the TIF, the risks associated with the profitability of
projects might be transferred from local governments to
developers if the realized profitability were lower than
expected.
Even if the realized profitability were higher
than expected, local governments might exploit excess profits
from developers.
Therefore, once the redevelopment agreement is fixed
between the local government and developers, the local
government is concerned only with the profitability of the
project, whereas the developers should be concerned not only
with the profitability but also with the possible risk
transfers by the local government.
1.1.4 CAPITAL PARTNER'S OVERALL BUSINESS POSITION
The Capital Partner B Corp. is, as was mentioned before,
a subsidiary fully owned by the Japan-based construction and
engineering firm and was recently established in the United
States.
At the time when they decided to get involved in the
case project, their business size in the United States was
insignificant, compared to the other U.S. real estate firms.
As are usual with start-up firms, they were operating in the
deficit, and they expected to get out of the deficit at
fastest 10 years later from the time of entry.
~1·'L~I~_
PAGE 186
One of the motivations which drove the Japan-based
construction and engineering firm to set up a subsidiary in
the United States is to take advantage of the financing
capabilities due to high credibility and reputation in the
business, and close relationship with Japanese banking
institutions.
Because, in this early stage of the
subsidiary, they did not have advantageous information to the
other competitors, their chief advantage is assumed to be its
financing capabilities only.
In this sense, the case project
is a pure investment for the Capital Partner, and the
profitability of the project seriously affects the
subsidiary's overall accounting position, though growth
opportunities may be obtained by undertaking the case
project.
However, since the Capital Partner was operating in the
deficit, the tax position substantially affects the
profitability of the project, and vice versa.
Therefore, for
the Capital Partner, the tax position should be one of the
main concerns in evaluating the project in the circumstances
surrounding the Capital Partner at the time.
The V.C.
methodology will effectively analyze the interactions
between the Capital Partner's tax position and the
profitability of the project for the Capital Partner in later
section.
__
-----~---~-
·
PAGE 187
1.2.
EXAMINING ADEQUACIES OF ORIGINAL ASSESSMENT OF
CASE PROJECT
1.2.1 ORIGINAL ANALYSIS AND RESULT
In the original assessment report of the case project,
a return on equity before tax, property resale , and
repayment of the principal of the loan is calculated by using
the Internal Rate of Return rule.
In this original
assessment report by the accounting firm, for an unknown
reason, the interest repayments on the 20-year balloon loan
are subtracted from the cash flows, but the principal
repayment at the maturity date is not subtracted from the
cash flows.
Similarly, the tax-related cash flows are not
included in the cash flows, and the resale value of the
property is not added to the cash flows.
ignoring these cash flows are also
Reasons for
unknown. The forecasted
net cash flows before tax, property resale and repayment of
the loan principal, and the return on equity
the Table below.
Wadi
i .-
are shown in
PAGE 188
Table-17: Net Cash Flow Forecast before Tax, Property Resale,
and Repayment of Loan Principal after Interest and
IRR
Year
Net Cash Flows (000$)
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
-24,200
0
0
0
669
2,840
3,354
4,241
5,174
6,133
7,150
8,229
9,374
10,588
11,877
13,244
14,694
16,232
17,864
19,595
21,454
23,427
IRR
16.0 %
The assessment shown above is a halfway result because
1) the assessment does not incorporate the cash flows
associated with the tax imposed and tax shields in relation
to the tax positions of each partner, and 2) the assessment
does not include the cash flows associated with resale of the
property and the principal repayment. However, since the
assessment report does not tell more than the result shown in
the above Table, the assessment could mislead the decisionmakers.
Some might argue that the assessment report is
satisfactory 1) because the IRR of 16% is on a safer side,
assuming that the resale value of the property would be
i_ Ii
i
PAGE 189
higher than the amount of the loan principal, and 2) because
the tax effects would not be significant to each partner as
long as the project generates a positive value, though taxrelated cash flows could change the value of the project.
In
some particular circumstances, the argument might be valid.
However, in this case, the argument is incorrect because the
assessment report has methodological errors in itself.
These
methodological errors are discussed in next sub-section.
1.2.2 ERRORS IN GENERAL ASSUMPTION AND EVALUATION METHODOLOGY
The general errors inherent to the IRR rules were
already discussed in Chapter 1.
In addition to the general
errors, the following errors specific to the assessment of
the case project should be pointed out.
The first and important error is in their general
assumption that the cost of equity is 10% whereas the longterm borrowing rate is 11%.
This assumption on the cost of
equity is intuitively incorrect because the cost of equity
should be higher than the borrowing rate of 11%, reflecting
the higher risks to the equity-holders than to the
bondholders.
If, in the general assumption, the
equityholders shifted their project risks to the bondholders,
the lower cost of equity might be possible.
However, the
general assumption in the assessment report is a normal longterm loan form commercial bankers.
equity should be higher than 11%.
Therefore, the cost of
PAGE 190
The most serious effect of the assumption on the
decision-making is that the decision-makers might accept the
case project simply because the IRR of 16% is higher than the
cost of equity of 10%.
judgement.
However, this is obviously wrong
The original appraisers could have calculated the
10% as WACC so that they might have obtained the costs of
equity of 10%, which is lower than the borrowing rate.
this is also wrong.
But,
Therefore, it in necessary to estimate
the correct cost of capital for the case project.
A rough estimate can be obtained from the results in the
Table-6: Unleveraged Betas of U.S. Real Estate Firms of
Chapter 4.
An unleveraged beta of 0.34, which is calculated
based on the long-term ZCAPM for the U.S. investors, is cited
from the Table.
However, since the unleveraged beta is for
the all-equity financed projects, the unleveraged beta should
be leveraged according to the debt-to-equity ratio of 4.43
( The equity is $ 24,200,000 out of the total expenditure
$~ 131,329,000)
of
costs
1~IJZ~,UUU)
o~
costs
IRR
the
with
compared
be
to
in
order
tne
IKK
witn
De
comparea
orcier
to
In
of
1.76
beta
leveraged
the
leveraged. Thus,
is
which
of
16%,
1.76
beta
of
leveraged
the
Thus,
is
leveraged.
which
of
16%,
the
of
ratio
debt-to-equity
the
that
assuming
is
obtained,
of
the
ratio
the
debt-to-equity
that
assuming
obtained,
is
periods.
project's periods.
the project's
constant over
project isis constant
case project
over
the
case
22.27% inin
equity of
levered equity
cost ofof levered
real cost
the
Consequently,
of
22.27%
the
real
Consequently,
formula(25)
by
using the
obtained
is
terms
real
formula(25)
the
by
using
obtained
terms
is
real
.
we
If
If
we
consistent with
which isis consistent
5%, which
rates ofof 5%,
inflation rates
annual inflation
assume annual
with
assume
nominal
the nominal
report, the
assessment report,
the assessment
made inin the
assumption made
the assumption
the
28.39%.
would bebe 28.39%.
equity would
levered equity
cost ofof levered
cost
16%
IRR ofof 16%
If thethe IRR
If
equity ofof
cost ofof levered
nominal cost
with thethe nominal
compared with
were compared
equity
levered
were
i
II~
PAGE 191
28.39%, the decision-maker would not have accepted the case
This is what the IRR rule tells the decision-maker
project.
However, this is not the end of the story.
what to do.
The second error closely related to the results of the
The general IRR method
first error discussed above.
a
calculates
the
return
by
zero,
project
of
on
the
equity
which
return
makes
the
,
all
the
incorporating
However,
project.
"
rate
cash
a
major
NPV
of
the
to
relevant
flows
the
calculates
report
assessment
excluding
the
of
portion
the
capital expenditures, which are financed with debt.
Thus,
the IRR calculated in the original assessment is leveraged.
If the decision-maker compares the leveraged IRR with the
cost of equity of 10%, it could mislead the decision-makers.
If we exactly follow the IRR method, the cash flows have
to include all the cash flows relevant to the project,
including the tax-related cash flows, salvage values, and the
repayment of the loan principal.
Then, based on these cash
fl1 %ws
.
-i
hk
RMi1
t ts
e IRO
Lna
1
cacu
1 ae4- A
anL
ll y,
tL e
Th
4R
s
compared with the compatible hurdle rate. The net cash flow
forecasts adjusted before tax-related cash flows and after
tax-related cash flows, and IRRs are shown in the Table-19
below, assuming the effective tax rate to be 34%.
PAGE 192
Table-18: Adjusted Net Cash Flow Forecasts before and after
Tax-Related Cash Flows, and IRR
(000$)
Year
Before Tax
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
-23,487
-53,842
-28,223
- 3,316
12,381
14,588
15,102
15,989
16,922
17,881
18,898
19,977
21,122
22,336
23,625
24,992
26,442
27,980
29,612
31,343
33,202
161,595
IRR
After Tax
13.40%
- 23,487
- 53,842
- 22,229
1,703
16,030
17,225
17,570
16,821
16,983
17,569
18,216
18,928
19,364
20,166
21,017
21,919
22,876
23,891
24,968
26,110
25,907
76,375
13.72%
The compatible hurdle rate (cost of equity) is calculated by
using the unleveraged beta of 0.34 based on the formula(25).
Thus, the real hurdle rate of 7.79% is obtained.
Therefore,
the compatible hurdle rate in nominal terms is 13.18%,
incorporating annual inflation rates of 5%.
Since the IRRs
before and after tax of 13.40% and 13.72% are larger than the
compatible hurdle rate of 13.18%, the project is acceptable
according to the IRR decision rule, regardless of the tax
position of the participants.
However, the above conclusion obtained by the IRR rule
could be still erroneous due to the other methodological
errors inherent to the IRR rule, which were discussed in
I
PAGE 193
Chapter 2.
Therefore, the correct value of the case project
is not yet known at this point.
1.2.3
CONCLUSION
The original assessment is halfway and misleading
because it has twofold errors in addition to the
methodological errors inherent to the IRR method.
These are,
1) it does not take into account the tax effects, salvage
values, and principal repayment, and 2) the assumption on
cost of equity is inappropriate and the calculated IRR
is not compatible to the cost of equity due to its financial
leverage.
If the correct value of the case project, calculated
with more appropriate and correct methodology such as V.C.,
were positive, the decision-makers would be fortunate, and
otherwise, they were misled by the assessment report.
In
fact, since the original assessment report does not either
use tax-adjusted cost of capital, such as the ModiglianiMiller formula and the Miles-Ezzell formula, or try to
include thetax-related
the tax-related cash
cash flows,
flows, the
decision-makers would
would
include
the decision-maers
not have been certain about the tax effects.
In next section, the V.C. methodology is applied to the
case project in order to evaluate the case project in a
correct manner, and to analyze the conditions which must be
satisfied
so
as
to keep
keep the
the project
project value
value positive
positive enough
to
satisfied
so
as
to
enough
to
undertake.
undertake.
undertake.
Illlrl
PAGE 194
2.
V.C. APPLICATION TO CASE PROJECT
In this section, V.C.methodology is applied to the case
project, especially with regard to the issues raised in the
earlier
section.
First,
the
assessment
the
report
original
Second,
i
assumptions
overall~
overall
V.C.
~17~~m~
inco~mean
income
calculated
~17~
and
the
original
assumptions
are
are
in
additional
assumptions
the
their
their
and
employed
presented
in
and
+~Y
tax~
tax
compensating
consistent
examined
IAC~+~AnC
osiion
positions
manners.
in
~f
oP+A1
f
of
+h~
the~
the
for
relation
to
crnlli+~l--h~l~~rc
uTit+-holde~rs
e
equity-holders
in the
following
two
cases:
1)
the
base
case
when
a
single
the
following
two
cases:
1)
the
base
case
when
a
single
in
U.S. firm
imaginarily
undertakes
the
case
project,
and
2)
the
firm
imaginarily
undertakes
the
case
project,
and
2)
the
U.S.
real case
when
the
general
partners
of
the
U.S.developer
and
case
when
the
general
partners
of
the
U.S.developer
and
real
Japan's investors
undertake
the
case project
under
the
investors
undertake
the
case
projlect
under
the
Japan's
conditions
described
in
last
section.
conditions
described
in
last
section.
Finally,
the
issues
Finally,
the
issues
specific to
the case
case project
project are
examined
in
terms
of
the
to
the
are
examined
in
terms
of
the
specific
effects of
each
issues on
the
case
project,
each
partner's
of
each
issues
on
the
case
project,
each
partner's
effects
position.
position.
2.1.
GENERAL ASSUMPTIONS
ASSUMPTIONS
2.1.
GENERAL
The general
general assumptions
assumptions employed
in
the
evaluation
of
employed
in
the
evaluation
of
The
the case
case projects
are
briefly
discussed in
the
following
projects
are
briefly
discussed
in
the
following
the
order:
order:
1)
equity
contribution
&
split,
and
distribution of
1)
equity
contribution
&
split,
and
distribution
of
accounting
loss
&
profit;
accounting
loss
&
profit;
2)
financing;
2)
financing;
r
t,
C1__
PAGE 195
3) foreign exchange exposure and foreign exchange rate;
4) inflation rate and property appreciation rate;
5) operation;
6) depreciation and amortization schedule;
7) income tax and capital gain tax; and
8) cash flow component and discount rate.
2.1.1 EQUITY CONTRIBUTION & SPLIT, AND DISTRIBUTION OF
ACCOUNTING LOSS AND PROFIT
The equities of $ 24 million and $ 0.2 million are
contributed by the capital partner and the managing partner,
respectively.
However, the split ratio of the project's cash
flows and assets is 75% ( for the capital partner) to 25%
( for the managing partner ).
Therefore, in the V.C.
analysis, the cash flows associated with the operations of
the project are split to both partners with the above ratio,
whereas the project's accounting profits and losses are split
with the different ratio.
The project's accounting profits
and losses are split with a ratio of 96 (for the capital
partner) to 4 (for the managing partner) when the project's
accounting income is negative (loss), and with a ratio of 75
(for the capital partner) to 25 (for the managing partner)
when the project's accounting income is positive (profit).
Therefore, the taxes payable by both partners are determined
by each partners' overall income and tax positions, including
the accounting profits and losses associated with the case
1ý
Wd
PAGE 196
project.
Consequently, the total cash flows relevant to the
case project for each partners consist of three cash flow
components as follows:
Total Cash Flows
=
Equity + Operational Cash Flows + Cash Flows Related
to Taxes
Because the cash flows related to taxes are determined by
each partner's overall income and tax positions, the values
of the case project are partially dependent on each partner's
overall income and tax positions.
This is one of natures
inherent to the case project.
2.1.2 FINANCING
The financing scheme employed in the assessment is to
finance the case project with a short-term construction loan
during the construction period.
The interest rate of the
short-term loan is assumed to be 9.5% annually.
The
construction loan is switched to the 20-year balloon loan
just after the completion of the construction.
The interest
rate of the long-term balloon loan is assumed to be 11%, and
the principal of the loan is assumed to be repaid at the
maturity date.
PAGE 197
2.1.3 FOREIGN EXCHANGE EXPOSURE AND FOREIGN EXCHANGE RATE
The foreign exchange exposures relevant to the case
project are mainly those associated with the changes in the
nominal exchange rates.
The reasons are as follows.
1) Because 1) the expected main targets of the hotel
operations of the case project are those who do
business in the region, and 2) the relative changes
in currencies are not expected to increase the
revenues, the hotel operations are not likely to be
significantly affected by the changes in the real
exchange rates.
2) Because the office leasing targets those firms doing
business in the region, the office revenues are not
likely to be affected by the changes in the real
exchange rates.
3) Because
) theof exphe inpuctd
main targets
"'~
" ~ V I
of thers,
foodtels,
-VVUV~
'UUY'VI
utilities, and
etc. are
sourced
in
the
United
States,
and
etc.
are
sourced
in
the
United
States,
utilities,
the
costs
of the
the case
project
are
not
likely
to
be
the
costs
of
case
project
are
not
likely
to
be
affected byby the
the changes
changes in
the
real
exchange
rates,
in
the
real
exchange
rates,
affected
though the
the prices
prices in
U.S.
are, more
or
less,
affected
in
U.S.
are,
more
or
less,
affected
though
by the
the changes
changes inin the
real
exchange
rates.
the
real
exchange
rates.
by
Furthermore, the
the FX
FX risks
associated
with the
the changes
in the
risks
associated
with
changes
in
the
Furthermore,
nominal exchange
exchange rates
rates are
are chiefly
chiefly forfor Japan's
capital
Japan's
capital
nominal
partner because
U.S.managing partner's
partner's utility isis determined
determined
partner because
because U.S.managing
U.S.managing partner's utility
utility is determined
mainly inin terms
terms ofof U.S.
U.S. dollar.
dollar. Therefore,
henceforth, the
the
mainly
Therefore,
henceforth,
partner
FX risk
risk ofof the
the case
case project
project refers
to
the
FX
risks
for
refers
to
the
FX
risks
for
FX
i
-Magi
PAGE 198
Japan's capital partner associated with the changes in the
nominal exchange rates.
In the case project, Japan's capital partner takes a
perfectly long position in U.S. dollar because all the assets
and cash flows generated by the project are denominated in
U.S. dollar.
Therefore, the FX risks depends on the
deviation of the Yen-Dollar nominal exchange rates from IFE.
Therefore, in this simple structure of input and output, the
FX risk hedging would be achieved by the financial hedging
rather than the operational hedging.
However, there is a difficulty in estimating how much
the capital partner can remit excess cash flows in U.S.
dollar at each time.
If the operations are stabilized, and
the degree of certainty of the estimation is substantially
high enough, the capital partner could buy Japanese Yen in
forward contracts with the estimated excess dollars.
This is
easier to be applied to the cash flows from the office
leasing than those from the hotel operation, by assuming that
the costs associated with the office leasing, such as utility
costs, replacement costs, and etc, are predictable with small
variances, though the costs are not generally contractually
fixed.
For instance, because the office leasing contracts
are generally long-term contracts with fixed rents ( However,
some of them are adjusted according to the inflation rates
such as CPI index.) and because of the above assumption on
the costs, the capital partner could hedge the FX risks with
forward contracts whereas the most of the hotel revenues and
~
PAGE 199
costs are not contracted nor predictable within small
variances except for some long-term renting and etc.
In the following V.C. analysis, the hedging costs of the
FX risks are not incorporated in the expected cash flows 1)
because the capital partner does not intend to remit any
excess dollar to the parent company, but rather invest the
excess dollar in U.S., though the value of the case project
in terms of Japanese Yen is affected by the nominal exchange
rates, and 2) because the hedging costs would not be crucial
to the V.C. analysis of the case project.
In order to convert U.S. Dollar into Japanese Yen at
each time of the project's life,
the exchange rate of Yen
over Dollar is forecasted by the following simulation and the
term structure of U.S. and Japan's Government Bond.
The simulation is to locate an estimated trend of longterm nominal exchange rates, which are calculated based on
the IFE, using the differentials of short-term Treasury-Bill
yields, into the historical trend of the spot exchange rates
from 1973 to 1988 in a way to minimize variances between the
estimated long-term nominal exchange rates and historical
spot exchange rates.
The purpose of the simulation is to
look for the current (1985) equilibrium nominal exchange
rate, which might be different from the current(1985) spot
rate.
The results are shown in Figure 8: Estimating
Equilibrium Nominal Exchange Rates (Yen/$) Based on IFE.
The
PAGE 200
estimated trend seems to follow the historical trend of the
spot exchange rates quite well, which supports the validity
of the IFE in the long-run.
And, a cyclic behavior of the
Yen-Dollar exchange rate along the estimated equilibrium
nominal exchange rate is observed.
In this simulation, in
order to minimize the variances, the estimated exchange rate
at the first quarter of 1973 is set 280 Y/$ as opposed to the
historical exchange rate at the same period of 287.4 Y/$.
The difference is only 7 Y/$, which could be marginal enough.
In conclusion, the current (the fourth quarter of 1985)
equilibrium exchange rate is estimated to be 185 Y/$ , based
on the IFE as opposed to the current (the fourth quarter of
1985) nominal exchange rate of 207 Y/$.
The estimated
exchange rates of 185 Y/$ as opposed to the spot exchange
rate of 207 Y/$ might indicate that the market-determined
exchange rates might be biased so as to overappreciate U.S.
Dollar from the perspective of the historical long-term
equilibrium relations embedded in the term structure of
interest.
I
PAGE 201
400
300
YEN/ $ 200
100
0
_·_·I·__L__L_____I·
_··II·_II__·_______
___________________
______
1 6 1 1 223344556
1 616161616
MONTH
-
spot exchange rate
--- estimated exchange rate
Figure 8: Estimating Equilibrium Nominal Exchange Rates
(Yen/$) Based on IFE
PAGE 202
However, the current market-determined exchange rate of
207 Y/$ is used as the equilibrium nominal exchange rate for
forecasting the future exchange rate since the marketdetermined rates are considered to be generally most free
from any bias.
Instead, the exchange rates will be
forecasted based on the current (1985) spot rate (207Y/$) and
the estimated equilibrium rate (185Y/$) in the table below in
order to examine the effects of the forecasted exchange rates
later.
The next step is to forecast the future exchange rate,
using the term structure of the interest rate, that is, the
yield-to-maturity of the U.S. and Japanese government midand long-term bonds, some of which are chosen as the best
data available, some of which are estimated based on the data
available.
The result of the forecasted exchange rates over
the project's periods is shown in the table below.
PAGE 203
TABLE 19: Forecast of Exchange Rate from 1986 to 2007
year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
forecasted nominal exchange rate
base rate = 185 Y/$
base rate = 207 Y/$
180
175
171
166
162
157
153
149
145
141
138
134
130
127
124
121
118
114
111
109
106
103
201
196
191
186
181
176
172
167
163
158
154
150
146
142
139
135
131
128
125
121
118
115
The above table indicates that, as a long-term trend,
U.S.dollar would continue to depreciate against Japanese Yen
for the coming 20 years.
2.1.4 INFLATION RATE AND PROPERTY APPRECIATION RATE
The inflation rate in the U.S. is assumed to be annually
5% during the periods of the case project.
Because the
growth rates of the effective room rates and the average
annual office space rents are assumed to be 6%, assuming the
annual inflation rate of 5% would result in overestimating
the expected cash flows.
However, this inconsistency could
PAGE 204
be adequate if the case project has some excess value added
For instance, if the case project is
during the project.
certain to become a prime hotel or a prime office which can
attract price-insensitive customers due to its good services,
good locations, good reputations, luxurious images and etc,
the growth rates of the effective room rates and the average
annual office space rents could be higher than the average
However, it is
inflation rates over the project periods.
also true that the higher growth rates than the inflation
rates might affect the occupancy rates for price-sensitive
customers.
this
to
Because this is purely a matter of the marketing,
inconsistency
keep
is
of
But,
be
later
in
it
is
in
the
analysis
the
original
assessment
the
chapter,
this
in
order
and
the
inconsistency
examined.
the
Consequently,
automatically
as
compatibility
the
V.C.analysis.
will
left
estimated
inflation
according
rate
to
in
the
Japan
expected
is
annual
inflation rate in the U.S. of 5% and the expected exchange
rate of Japanese Yen over U.S. Dollar in previous section,
assuming that the PPP holds during the project's period (20
years).
The result of the expected inflation rate in Japan
is shown in the table below.
PAGE 205
Table 20 : Expected Inflation Rate in Japan
year
expected inflation rate (%)
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2.20
2.21
2.21
2.22
2.22
2.23
2.23
2.23
2.24
2.24
2.24
2.25
2.25
2.25
2.25
2.26
2.26
2.26
2.26
2.26
2.26
2.26
average 2.25 %
For simplicity, the expected inflation rates in the above
table are averaged, and the averagely expected inflation rate
of 2.25% is used in the project evaluation due to the small
variances of the estimated inflation rates.
The appreciation of the property ( the market value of
the building and land plus the value added minus the economic
depreciation of the building ) is assumed to be 2% real
annually.
Thus, the property tax is assumed to increase by
2% annually, assuming that the property tax rate would not
change during the project.
3i
r
i
PAGE 206
2.1.5 OPERATION
The assumptions on the operations of the case project
consist of those on hotel operations and office operations.
The major assumptions on the hotel operations are as
The number of the hotel rooms and the operation
follows.
days per year are assumed to be 483 rooms and 365 days per
The effective room rate is assumed to be
year, respectively.
$ 100 per room at the beginning of the operations and
i
ncrease
ll
annua
hand,
78%
75%,
constantly
78%
major
The
follows.
is
per
SF
SF.
in
1988
ra
of
e
hotel
the
o
r%
.
e
to
o
be
er
65%,
be
and
1991,
4thF
Vh
n
assumed
is
and
1989,1990,
1988,
6%
rf
t
grow
thereafter.
on
assumptions
The
357,000
e
rate
for
I
4k
th
y
occupancy
the
70%,
b
y
effective
The
and
growth rate of 6%.
office
annual
is
the
and
average
assumed
retail
rent
to
increase
are
operations
office
areas
for
for
leasing
annually
as
leasing
is
by
$26
the
On the other hand, the occupancy rate of
the office is assumed to be 40%, 65%, 90%, and 95%
for
1988,1989,1990, and 1991, and be constantly 95% thereafter.
2.1.6 DEPRECIATION AND AMORTIZATION SCHEDULE
The depreciation schedules are 18-year and 5-year
depreciations which are defined in the Accelerated Cost
Recovery System (ACRS) before the Modifies Accelerated
Recovery System (MACRS) in 1986.
And, the amortization
PAGE 207
schedule is 10-year straight-line amortization.
The 18-year
depreciation schedule is applied to the building and major
equipment, whereas the 5-year schedule is applied to such as
FF&E in hotel and Tenant Improvement in office building.
The
10-year straight-line amortization schedule is applied to the
interest costs associated with the short-term construction
The depreciation and amortization schedules are shown
loan.
in the table below.
Table 21 : Depreciation and Amortization Schedule
year
1
2
3
4
5
6
7
18-year (%)
9
9
8
7
7
6
5
10-year (%)
10
10
10
10
10
10
10
8
5
10
9
5
10
10
5
10
11
12
13
14
15
16
17
18
5
5
4
4
4
4
4
4
(ACRS)
5-year
(%)
15
22
21
21
21
However, due to the Tax Reform in 1986, the ACRS was
changed to the ACRS which is currently applied to the case
project.
Therefore, the effects of the MACRS will be
discussed later in subsection for the specific issues.
PAGE 208
2.1.7 INCOME TAX AND CAPITAL GAIN TAX
The income taxes imposed on each general partner are the
corporate income tax (for the capital partner) and the
individual income tax (for the managing partner),
respectively.
However, because the federal corporate and
individual income taxes for the general partners are assumed
to be very close, 34% and 33%, respectively, the income tax
of 34% is applied to both partners for simplicity.
(The
state income tax is ignored.)
The capital gain tax rate for the sales of the property
20 years after the operations is assumed to be the same as
the income tax rate.
2.1.8 CASH FLOW COMPONENT AND DISCOUNT RATE
The grouping of the cash flows is little different from
the general grouping in order to accommodate the following
i
points specific to the case project:
1) the differences in the distribution ratios of the
i
cash flows and accounting profits and losses, and
2) the differences in the contribution ratio and split
ratio of the equity.
As a result, in the V.C. analysis of the case project, the
i
cash flow components for the capital expenditure are replaced
with the equity contributions and debt services (interest and
PAGE 209
principal), whereas the other cash flow components are almost
unchanged.
The nominal discount rates for each cash flow components
are quoted from the real discount rates by the long-term
ZCAPM in chapter 3 or estimated according to the market rates
at the time of the evaluation as follows.
1) the nominal discount rate of the cash flows related
to the operations for U.S. investors
( per Table 10 in chapter 3 )
[ (1+0.0779)*(1+0.05)-1 ] * 100 = 13.18 %
2) the nominal discount rate of the cash flows related
to the debt and contracts for U.S.investors
( per U.S.market rate )
11%
3) the nominal discount rate of the cash flows related
to the operations for Japan's investors
(per Table 10 in chapter 3)
[ (1+0.0607)*(1+0.0225)-1 ] * 100 =
8.46 %
4) the nominal discount rate of the cash flows related
to the debt and contracts for Japan's investors
( per Japanese market rate )
6.5%
The following tables summarize the grouping of the cash
flow components and nominal discount rates in the base case
and the real case.
PAGE 210
Table 22 : Cash Flow Components and Nominal Discount Rate
cash flow components
nominal discount rate
U.S. developer
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service (interest and principal)
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
(%)
Japan's sub.
13.18
13.18
13.18
13.18
11.00
13.18
11.00
11.00
11.00
13.18
8.46
8.46
8.46
8.46
8.46
8.46
6.50
6.50
6.50
8.46
The cash flow forecasts employed in the V.C. analysis
are exactly identical to those in the original assessment in
order to keep their compatibility.
The sensitivity of the
V.C. values to the ranges of the forecasts of the crucial
cash flow components will be examined later in section
dealing with the specific issues.
2.2. V.C. OF BASE CASE
This sub-section calculate the V.C. of the case project
in case a single U.S. firm imaginarily undertakes the project
without paying any advance for the site acquisition costs.
The purpose of this sub-section examine the nature of the
project, that is, a question of what is the crucial element
affecting the profitability of the case project.
The table 23 summarizes the expected cash flows of the
base case, assuming that the firm has other taxable income
PAGE 211
enough to cover the accounting losses of the case project so
as to take advantages of the tax shields on depreciations,
amortizations, and interest.
Table 23-1 : Base Case
[Summary of Expected Cash Flows (000 US$)]
year
equity
fixed charges
gross income
from operation
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
-10,100
-10,100
- 4,000
0
0
5,660
10,493
13,919
16,207
16,764
17,697
18,677
19,684
20,752
21,883
23,083
24,354
25,701
27,129
28,642
30,246
31,946
33,748
35,681
37,731
-
0
0
1,496
1,536
1,576
1,619
1,663
1,708
1,755
1,804
1,854
1,907
1,961
2,017
2,076
2,137
2,200
2,266
2,334
2,405
2,479
2,556
changes in
working capital
0
- 9,593
6,917
2,675
PAGE 212
Table 23-2 : Base Case
[Summary of Expected Cash Flows
year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
debt service
0
0
-11,081
-11,633
-11,711
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-11,748
-118,548
(000 US$)]
salvage value
233,220
As was mentioned before, the interest on the principal is
repaid at each year
(from 1988 through 2007),
whereas the
principal is repaid at the maturity year of 2007.
OIL
PAGE 213
Table 23-3 : Base Case
[Summary of Expected Cash Flows (000 US$)]
year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
---------- tax shield on
depreciation
amortization
0
0
3,323
3,791
3,545
3,284
3,290
1,955
1,502
1,454
1,430
1,430
1,430
1,430
1,144
1,144
1,144
1,144
1,144
1,144
---------interest
0
0
319
319
319
319
319
319
319
319
319
319
income & CG
tax
0
0
3,768
3,955
3,982
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
3,994
0
0
- 1,416
- 3,046
- 4,197
- 4,960
- 5,135
- 5,436
- 5,754
- 6,079
- 6,425
- 6,792
- 7,182
- 7,594
- 8,032
- 8,497
- 8,990
- 9,513
-10,068
-10,657
-11,289
-89,214
The table below indicates the V.C. calculated with regard to
the base case according to the forecasts of the expected cash
flows and others earlier discussed.
The nominal discount
rates for each cash flow component is per Table 22: Cash Flow
Components and Nominal Discount Rate.
And, the capital
expenditure cash flows are replaced with the combination of
the equity contributions and debt services
in order to
afterwards evaluate the case project from the different
equity-holders viewpoints, as was discussed earlier.
PAGE 214
Table 24
V.C. of Base Case
(000 U.S. Dollar at the end of 1985)
cash flow components
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service (interest and principal)
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
V.C.
-
-
total
22,146
108,260
10,843
1,230
95,567
17,322
16,656
1,692
28,435
38,860
3,719
The V.C. analysis of the base case indicates that the
case project is acceptable under the assumptions.
However,
the V.C,.
clarifiesc the natulre
V.C. analysis clarifies
nature of the case
case projc~rt
project asc
as
follows.
The first clarification is that the economic return on
investment in the case project as opposed to the book return
on investment in the case project is quite marginal 3.16%,
which
V.C.value
which is
is the
the total
total
V.C.value of
of $
$ 3,719
3,719 divided
divided by
by the
the sum
sum of
of
the
contribution and
the V.C.
V.C. of
of equity
equity contribution
and the
the V.C.
V.C. of
of the
the debt
debt
service.
service.
This
This marginal
marginal economic
economic return
return on
on investment
investment
(ROI)
(ROI)
implies
that the
implies that
the case
case project
project is
is probably
probably not
not profitable
profitable
enough
enough to
to accommodate
accommodate unexpected
unexpected changes
changes or
or mis-forecasts
mis-forecasts of
of
the
the expected
expected cash
cash flows.
flows.
The
clarification is
the
of
The second
second clarification
is that
that
the profitability
profitability
of
the case
the
case project
project is
is not
not due
due to
to the
the operations,
operations, but
but rather
rather due
due
to
take.
to the
the tax
tax shields
shields which
which the
the firm
firm is
is supposed
supposed to
to take.
If
If
the firm
the
firm is
is assumed
assumed to
to have
have accounting
accounting losses
losses which
which exceed
exceed
the
accounting income
case
over
the
the
income from
from the
the
case project
project
over
onivsmn accounting ntecs
rjeti
ut
agnl31% the
I
MMIAYI
PAGE 215
project's period, the V.C.of the case project turns out to be
negative, - $ 4,204,000.
Thus, the case project is not
acceptable if the firm is not in a position in paying taxes
or if the firm or investors can not take advantage of the tax
shields by shielding other income or by deferring the tax and
tax shields.
This is because the total V.C. of the tax
shields on depreciation, amortization, and interest,
$ 46,783,000 is a real source of the profitability.
The
second clarification implies that the profitability of the
case project is mainly dependent on the firm's tax position
because the V.C. without tax payments and tax shields is a
negative number, - $ 4,204,000.
In conclusion. the V.C. analysis revealed the nature of
the case project, that is,
1) the marginal profitability of
the case project, and 2) the project's crucial dependence on
the firm's tax position.
This nature of the case project is
also crucial in the real case, which will be analyzed in next
section.
2.3. V.C. OF REAL CASE
This sub-section calculate the V.C. of the case project
in the real case when the managing and capital partner
undertake the project, assuming that the capital partner does
not pay any advance fore the site acquisition costs.
( The effects of the advances will be discussed later.)
PAGE 216
The table 25 and 26 summarizes the expected cash flows
of the real case for the U.S.managing partner and for Japan's
capital partner,respectively.
The tables assume that both
partners have other taxable income enough to cover the
accounting losses of the case project so as to take
advantages of the tax shields on depreciations,
amortizations, and interest.
However, later in this section,
the tax-related cash flows for the Japan's capital partner
are modified so as to adequately express the capital
partner's tax positions.
First of all, the V.C. for U.S.managing partner is
calculated and analyzed, and finally, the V.C. for Japan's
capital partner is calculated and analyzed.
ýi
PAGE 217
Table 25-1 : Real Case
[Summary of Expected Cash Flows (000 US$)
for U.S. developer]
year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
equity
-
200
gross income
fixed charges
from operation
0
0
1,415
2,623
3,480
4,052
4,191
4,424
4,669
4,921
5,188
5,471
5,771
6,088
6,425
6,782
7,161
ZUU.3
I,
2004
2005
2006
2007
7,986
8,437
8,920
9,433
bi
-
changes in
working capital
0
0
374
384
394
405
416
427
439
451
464
477
490
504
519
534
550
-
bb
-
583
601
620
639
0
- 2,398
1,729
669
PAGE 218
Table 25-2 : Real Case
[Summary of Expected Cash Flows (000 US$)
for U.S. developer]
year
debt service
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
0
0
- 2,770
- 2,908
- 2,928
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
- 2,937
-29,637
salvage value
58,305
PAGE 219
Table 25-3 : Real Case
[Summary of Expected Cash Flows (000 US$)
for U.S. developer]
year
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
---------- tax shield on ----------depreciation amortization interest
0
0
133
152
142
131
132
78
60
364
358
358
358
358
286
" 286
286
286
286
286
0
0
0
0
13
13
13
13
13
13
13
80
80
80
0
0
151
158
159
160
160
160
160
999
999
999
999
999
999
999
999
999
999
999
999
999
income & capital
gain tax
0
0
57
122
- 168
198
- 205
- 217
- 230
-1,520
-1,606
-1,698
-1,795
-1,899
-2,008
-2,124
-2,248
-2,378
-2,517
-2,664
-2,822
-22,304
PAGE 220
Table 26-1 : Real Case
[Summary of Expected Cash Flows (000 US$)
for Japan's subsidiary ]
year
equity
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
-24,000
gross income
fixed charges
from operation
0
0
4,245
7,870
10,440
12,155
12,573
13,273
14,008
14,763
15,564
16,412
17,312
18,265
19,275
20,347
21,482
22,684
23,959
25,311
26,761
28,298
-
0
0
1,122
1,152
1,182
1,214
1,247
1,281
1,316
1,353
1,391
1,430
1,471
1,513
1,557
1,603
1,650
1,699
1,750
1,804
1,859
1,917
changes in
working capital
0
- 7,195
5,188
2,006
PAGE 221
Table 26-2 : Real Case
[Summary of Expected Cash Flows (000 US$)
for Japan's subsidiary]
year
debt service
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
0
0
- 8,311
- 8,725
- 8,783
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
- 8,811
-88,911
salvage value
174,915
PAGE 222
Table 26-3 : Real Case
[Summary of Expected Cash Flows
for Japan's subsidiary]
year
---------- tax shield on ----------depreciation
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2.3.1
amortization
0
0
3,190
3,640
3,404
3,153
3,159
1,877
1,422
1,091
1,073
1,073
1,073
1,073
858
858
858
858
858
858
0
0
interest
0
0
306
306
306
306
306
306
306
239
239
239
(000 US$)
income & capital
gain tax
0
0
3,617
3,797
3,823
3,835
3,835
3,835
3,835
2,996
2,996
2,996
2,996
2,996
2,996
2,996
2,996
2,996
2,996
2,996
2,996
2,996
0
0
- 1,359
- 2,924
- 4,029
- 4,762
- 4,929
- 5,219
- 5,523
- 4,559
- 4,819
- 5,094
- 5,386
- 5,696
- 6,024
- 6,373
- 6,743
- 7,135
- 7,551
- 7,992
- 8,467
-66,911
V.C. FOR U.S. MANAGING PARTNER
The result of the V.C. for U.S. managing partner is
shown in the table below.
The table also indicates the V.C.
for the capital partner in case that, instead of Japan's
capital partner, the U.S. capital partner imaginarily
participate in the case project
PAGE 223
Table 27
: V.C. of Real Case for U.S. Managing Partner
(000 U.S. Dollar at the end of 1985)
cash flow components
V.C.
managing partner capital partner
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
-
-
188
27,065
2,711
308
23,892
4,331
1,412
139
3,594
6,502
- 21,958
81,195
2,711
923
- 71,675
12,992
15,244
1,553
24,841
- 32,357
2,940
779
The above V.C. analysis indicates the following points
with regard to the risk and return trade-off between the
partners, and the cash flow structures for the managing
partner.
The first point is that the conditions given to both
partners of the case project is favorable to the managing
partner, at least in a sense that the V.C. for the managing
partner is 3.77 times larger that that for the capital
partner.
The advantages for the managing partner are derived
mainly from 1) the marginal equity contribution, and 2) the
relatively high equity split ratio compared to the equity
contribution.
Because it is not known how the compensation
scheme between both partners were practically determined, it
is speculative to judge whether or not the compensation
scheme agreed between the partners are adequate, given the
real situations.
IIIIII
However, at least, the V.C. analysis can
PAGE 224
show the compensations to both partners in explicit amounts
so that it would help to determine compensation schemes
between partners.
The second point is that the V.C. structure for the
managing partner is improved in favor of the managing
partner, compared to the V.C. structure of the base case,
which is found to be marginally profitable and dependent on
the tax positions of the firm.
ROI
First of all, the economic
(the ratio of the total V.C. value to the sum of the V.C.
values of the equity contribution and the debt services) for
the managing partner is 12.21 %, whereas the economic ROI of
the base case is 3.16 %.
Secondly, even if the managing
partner is not in a position of paying tax, the V.C. of the
case project for the managing partner is positive,
$ 4,297,000, which is obtained by adding the income & capital
gain taxes of $6,502,000 to and subtracting the tax shields
of $1,412,000, $139,000, and $3,594,000 from the total V.C.
of $2,940,000.
Thus, the managing partner is free from his
tax positions.
Consequently, under the given compensation
scheme, the managing partner successfully modified the
V.C.structure in favor of himself by sacrificing the V.C.
structure of the capital partner.
This is generally the case
with the real estate development in U.S., and might be one of
possible reasons why the U.S. capital partner, who were
originally supposed to finance the case project, retired from
the project.
PAGE 225
However, the V.C. structure for the foreign capital
partner could be different from that for U.S. capital partner
so that the foreign capital partner might be motivated to
finance the case project.
2.3.2
This is examined in next section.
V.C. FOR JAPAN'S CAPITAL PARTNER
The results of the V.C. for Japan's capital partner are
shown in the tables below.
The Table 28 is for a case that
the capital partner has other source of income enough to pay
tax over the project's periods, whereas the Table 29 is for a
case that the capital partner delay the tax payments exactly
10 years, resulting in the delay of the tax shields.
The
nominal discount rates for Japan's capital partner is per
Table 22 in section 2.1.8 Cash Flow Components and Discount
Rate.
Table 28 : V.C. of Real Case for Japan's Capital Partner
with timely tax payment
(000 Japanese Yen at the end of 1985)
cash flow components
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
V.C.
-
-
4,466,580
19,198,337
1,882,179
165,268
16,774,758
3,654,797
3,344,253
339,375
5,627,039
7,801,869
1,073,149
PAGE 226
Table 29 : V.C. of Real Case for Japan's Capital Partner
with delayed tax payment
(000 Japanese Yen at the end of 1985)
V.C.
cash flow components
-
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
-
-
4,466,580
19,198,337
1,882,179
165,268
16,774,758
3,654,797
1,363,907
138,344
2,302,664
2,683,136
686,129
total
The results are converted into U.S. Dollar as of the
ending of 1985 in order to compare the V.C. structure for the
imaginary U.S. capital partner calculated previously in Table
27.
The comparison table is shown below.
Table 30 : Comparison of V.C. for Capital Partner
1985)
at the
end of
(0o
00 T•_ Dnllar
V.C.
cash flow components
U.S. partner
Japan's partner
timely
tax
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
delayed
tax
- 21,958
81,195
2,711
923
- 71,675
12,992
15,244
1,553
24,841
- 32,357
- 21,578
92,746
9,093
798
- 81,037
17,656
16,156
1,639
27,184
- 37,690
- 21,578
92,746
9,093
798
- 81,037
17,656
6,589
668
11,124
- 12,962
779
5,184
3,315
PAGE 227
The above table shows dramatic changes in V.C. structure
for the capital partners.
The first point is that the V.C. for Japan's capital
partner is substantially higher than that for U.S. capital
partner.
The economic ROI's
( the ratio of the total V.C. to
the sum of the V.C. of the equity contributions and the debt
services) for the first two case are 0.83 % and 5.05 %,
respectively.
This is caused mainly by the increase in the
differentials of the V.C. of the cash flows associated with
the gross income from operations minus debt services, that
is,
"international financing effect" discussed in chapter 3.
" The international financing effect" discussed earlier
is as follows.
Because foreign investors
(in the case
project, Japan's investors whose portfolios consist primarily
of the domestic market portfolios)
live in their mostly
segmented economies and consumption bases, and because the
correlations of the foreign investors' market portfolios with
U.S. assets are generally smaller than those of U.S.
1
investors' market portfolios with identical U.S. assets.
Thus, the riskiness of the U.S. assets for the foreign
investors are generally lower than that for the U.S.
investors. Therefore, the identical cash flows have different
values to the foreign and domestic investors because the
discount rates for the foreign investors are generally
smaller than those for the domestic investors if the IFE
1 See Solnik[1988].
PAGE 228
holds well.
project.
Rate.)
This general statement is true in the case
(See Table 22: Cash Flow Component and Discount
Therefore, Japan's capital partner's financing the
U.S. project is advantageous to them
because the riskiness
of the cash flows generated by the U.S. project is small
enough for Japan's capital partner to undertake the case
project, though the case project is not attractive for U.S.
capital partner due to high correlation of the case project
with their market portfolios..
The second point is that the project's dependence on the
tax positions changed in a way to reduce the dependence.
the imaginary U.S. capital partner, the V.C.,
For
in case of no
tax and tax shields, drops to minus $ 8,502,000 as opposed to
minus $ 2,105,000 for Japan's capital partner, whereas U.S.
capital partner's V.C.,
in case of tax and tax shields, is
$ 779,000 as opposed to $5,184,000
for Japan's capital
partner.
This is really a better change for Japan's capital
partner.
Thus, "international financing effect" changed the
V.C. structure in favor of foreign investors.
Here is
another rationale for Japan's capital partner to finance the
case project.
The third case when Japan's capital partner delays the
timing of paying tax is the case closest to the reality for
Japan's capital partner in this case.
As the V.C. analysis
indicates, the case project is still acceptable, given the
assumptions.
However, the V.C. decreases by delaying the tax
PAGE 229
payments because the tax shields are still main drivers of
the project's profitability.
Therefore, as long as the case
project is concerned, delaying the tax and tax shields has
negative effects on the value of the case project.
Furthermore, if Japan's capital partner is not a position of
paying tax over the project's period, the case project should
not be acceptable even to Japan's capital partner, because
the V.C. drops to minus $2,105,000.
Consequently, "international financing effect" motivates
Japan's capital partner to finance the case project, but the
nature of the case project, that is, the project
profitability's dependence on the tax position, is not
eliminated, but reduced.
2.4.
SPECIFIC ISSUES
This sub-section briefly discusses the issues specific
to the case project.
The discussed are 1) the sensitivities
of the case project to the growth rate of the hotel room rate
and office rent, to the occupancy rate of the hotel and
office, to the forecast of Yen-Dollar exchange rates, to the
modified depreciation schedule, 2) concessionary sales price
of the site and advances for the acquisition costs, 3)
financing with revolving line of credits, and 4) the optimal
compensation scheme.
The sensitivity analyses or simulations implemented in
the following should be compared to the V.C.analysis in the
PAGE 230
previous section for U.S. managing partner and Japan's
capital partner who defers the tax payments exactly 10 years
after the taxes and tax shields are incurred.
The original
V.C.analysis is quoted below from the previous section.
Table 31 : Original V.C. Analysis
(000 U.S. Dollar at the end of 1985)
cash flow components
V.C.
U.S. partner
-
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
-
-
total
Economic ROI (%)
V.C. without tax-related components
(000 $)
2.4.1.
Japan's partner
delayed tax
188
27,065
2,711
308
23,892
4,331
1,412
139
3,594
6,502
- 21,578
92,746
9,093
798
- 81,037
17,656
6,589
668
11,124
- 12,962
2,940
3,315
12.21
4,297
-
3.23
2,104
SENSIYIVITY TO GROWTH RATE OF
HOTEL ROOM RATE AND OFFICE RENT
As was discussed in the assumptions on the expected cash
flows, the growth rates were assumed to be 6%, whereas the
inflation rates to be 5%.
This implies that the original
assessment expected the case project to achieve premium
revenues of 1% over the expected inflation rate of 5%.
The
PAGE 231
sensitivity analysis to the growth rate is implemented,
assuming that the case project could not achieve the premium
The
revenues of 1%, that is, the growth rate stays at 5%.
following table shows the result when the growth rate is 5%.
Table 32 : Sensitivity of Growth Rate
(000 U.S. Dollar at the end of 1985)
V.C.
cash flow components
U.S. partner
-
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
-
-
total
Economic ROI (%)
V.C. without tax-related components
(000 $)
188
25,260
2,711
314
23,892
4,331
1,412
139
3,594
5,995
Japan's partner
delayed tax
- 21,578
86,213
9,093
814
- 81,037
17,656
6,589
668
11,124
- 12,159
1,635
-
2,431
6.79
2,485
-
- 2.37
8,653
The result is that the capital partner's V.C. turns out
negative, minus $2,431,000 whereas the managing partner's
V.C. still remain positive.
This implies that the capital
partner is more vulnerable to the unexpected changes or misforecast in the growth rate whereas the managing partner
successfully locked in a position of being less affected by
them.
Thus, the unsystematic risks born by the capital
PAGE 232
partner is substantially larger than that of the managing
partner with regard to the unexpected changes in
the growth
rates as long as the case project is concerned.
However, from the U.S. managing partner's viewpoint, it
is quite reasonable and necessary to lock in such a position
because the portfolio held by the managing partner mainly
comprises U.S. regional real estates so that the portfolio is
not assumed to be well diversified.
Thus, by changing the
probability distributions of his real estates assets returns,
the managing partner changed the probability distributions of
his portfolio's return in order to eliminate the unsystematic
risks of his portfolio.
Otherwise, the managing partner
would be exposed to the strong unsystematic risks of his notwell diversified portfolio.
On the other hand, if the capital partner's portfolio is
well diversified, the unsystematic risk of the case project
could be diversified away.
Because, when the case project
was initiated, the capital partner's portfolio is not well
diversified, the capital partner is exposed to the
unsystematic risks of the case project to a great extent.
Therefore, it is necessary for the capital partner to examine
and hedge against the unexpected changes in the growth rates,
subject to the conflicts of the risk-return trade-offs with
the managing partner.
A way of hedging the unsystematic
risks of the case project will be discussed later.
PAGE 233
2.4.2.
SENSITIVITY TO OCCUPANCY RATE OF HOTEL AND OFFICE
One of major difficulties in the marketing of the case
project is to predict the occupancy rates over the project's
The
periods, especially at the beginning of the operations.
following tables are the V.C. based on the different
assumptions on the occupancy rate of the hotel and office.
The Table 33 assumes the office occupancy rates of the first
five years to be 30%, 50%, 70%, 85%, and 95% instead of the
original assumptions of 40%, 65%, 90%, 95%, and 95%, and the
Table 34 assumes the hotel occupancy rates of the first six
years to be 55%, 60%, 65%, 70%, 75%, and 78% instead of the
original assumptions of 65%, 70%, 75%, 78%, 78%, and 78%.
Table 33 : Sensitivity to Office Occupancy Rate
(000 U.S. Dollar at the end of 1985)
V.C.
cash flow components
U.S. partner
Japan's partner
delayed tax
-
-
equity contribution
gross income from operation
188
21,578
26,254
90,244
fixed charges
changes in working capital
debt service
2,711
398
- 23,892
9,093
1,034
- 81,037
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
4,331
1,412
139
3,594
17,656
6,589
668
11,124
6,458
- 12,593
2,083
946
income and capital gain tax
total
Economic ROI (%)
V.C. without tax-related components
(000 $)
-
8.65
3,396
-
0.92
4,842
PAGE 234
Table 34
: Sensitivity to Hotel Occupancy Rate
(000 U.S. Dollar at the end of 1985)
V.C.
cash flow components
U.S. partner
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
Economic ROI (%)
V.C. without tax-related components
-
-
Japan's partner
delayed tax
188
26,393
2,711
386
23,892
4,331
1,412
139
3,594
6,466
- 21,578
90,676
9,093
1,002
- 81,037
17,656
6,589
668
11,124
- 12,657
2,226
1,346
9.42
3,547
-
1.31
4,378
(000 $)
As is the same with the sensitivities to the growth
rates, the capital partner's position is more vulnerable to
the unexpected changes in the occupancy rates, whereas the
managing partners are independent of the risks.
This is
another indication that the capital partner bears the
unsystematic risks of the project, to a great extent, which
should be hedged as was discussed in the previous section.
2.4.3.
SENSITIVITY TO FORECAST OF YEN-DOLLAR EXCHANGE RATE
The original V.C. was calculated according to the
forecasted exchange rates which used the current (as of
ending of 1985) spot exchange rate as a base exchange rate.
PAGE 235
Here, the earlier-estimated equilibrium exchange rates based
on the historical behavior of the Yen-Dollar exchange rates
and IFE are used to calculate the V.C.of the project.
the
result is shown in the table below.
Table 35 :
Sensitivity to Exchange Rate Forecast
(000 U.S. Dollar at the end of 1985)
cash flow components
V.C.
U.S. partner
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
-
-
188
27,065
2,711
308
23,892
4,331
1,412
139
3,594
6,502
-
-
2,940
total
Economic ROI (%)
V.C. without tax-related components
(000 $)
-
Japan's partner
delayed tax
12.21
4,297
19,299
82,901
8,127
704
72,661
16,121
5,928
597
10,143
12,152
2,747
-
2.99
1,769
The result indicates that the variances of the
forecasted exchange rates do not seriously affect the capital
partner's V.C..
This is probably one of the characteristics
of the case project that the value of the project is not in
the operations, but rather in the tax shields due to large
depreciable value of the buildings and large amount of debt.
If the strength of the case project were the profitable
operations, the V.C. would have been affected more.
PAGE 236
This result is compared to next result, which examined
the sensitivity to the depreciation schedule.
2.4.4.
SENSITIVITY TO MODIFIED DEPRECIATION SCHEDULE IN
MODIFIED ACCELARATED COST RECOVERY SYSTEM (MACRS) IN
1986
The effects of changing the depreciation schedule is
measured in this simulation.
The depreciation schedule
employed here is the 31.5- year straight line depreciation
regulated in 1986 instead of the 18-year depreciation
schedule employed in the original V.C..
The result is shown
below.
Table 36:
Sensitivity to Modified Depreciation Schedule
(000 U.S. Dollar at the end of 1985)
cash flow components
V.C.
U.S. partner
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
Economic ROI (%)
V.C. without tax-related components
(000 $)
-
-
Japan's partner
delayed tax
188
27,065
2,711
308
23,892
4,331
977
139
3,594
6,502
- 21,578
92,746
- 9,093
798
- 81,037
17,656
4,133
668
11,124
- 12,962
2,505
859
10.40
4,297
-
0.84
2,104
PAGE 237
The result indicates that the capital partner's V.C.
drops to marginal amount of profits whereas the managing
partner's V.C. is little affected by the MACRS.
Because the
depreciation schedule is subject to the regulations, the
capital partner is fully exposed to the unexpected changes in
the depreciation schedule.
In fact, the MACRS is currently
applied to the case project, affecting the capital partner's
whereas the managing partner is little affected.
V.C.,
This
is another source of the unsystematic risks born by the
capital partner.
Comparing the effects of the forecasted exchange rates
and modified depreciation schedule reveals that, for the
capital partner, the risks associated with the unexpected
changes in the foreign exchange rates are substantially
smaller than those associated with the unexpected changes in
the depreciable value of the project.
Thus, the capital
partner should have hedged against the unique risks.
2.4.5.
CONCESSIONARY SALES PRICE OF THE SITE AND ADVANCES
FOR THE ACQUISITION COSTS
As was discussed earlier, the costs of the acquisition
and clearance of the site are financed with TIF(Tax
Incremental Financing) by the local government.
Furthermore,
the local government sold the site to the general partners
for a considerably discounted price, which attracted the
--arr
PAGE 238
general partners.
The reason that the local government sold
the site for a concessionary sales price is that the local
government expects the project to stimulate the local
economy, resulting in a increase in tax revenues.
The simulation implemented here is when the project does
not vitalize the local economy enough for the local
government to recover the loss incurred by the concessionary
sales of the site.
Because the major sources of the revenues
for the local government are tax revenues, the regulations of
the tax rates and taxable amount are subject to the balance
of the gross revenues and gross expenses.
Therefore, it is
not likely that the case project only is subject to the risks
of the increases in the property taxes, but the project is
still exposed to the unexpected changes in the property taxes
which are, to some extent, related to the project's success
or failure.
The result of the simulation when the property
appreciation rate is 4% as opposed to 2% in the original V.C.
analysis is shown below.
PAGE 239
Table 37
Sensitivity to Appreciation Rate of Property
(000 U.S. Dollar at the end of 1985)
V.C.
cash flow components
U.S. partner
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
Economic ROI (%)
V.C. without tax-related components
-
-
Japan's partner
delayed tax
188
27,095
3,005
309
23,892
4,331
1,412
139
3,594
6,431
- 21,578
92,857
- 10,149
802
- 81,037
17,656
6,589
668
11,124
- 12,845
2,746
2,483
11.40
4,032
-
2.42
3,053
(000 $)
The result indicates that the increases in the property
appreciation rates do not seriously affect the V.C. of both
partners, but that the managing partner is in a position of
being less affected by the unexpected changes in the property
taxes.
2.4.6.
FINANCING WITH LONG-TERM DEBT VERSUS REVOLVING LINE
OF CREDIT
The original IRR assessment by the accounting firm and
the original V.C. analysis are based on the assumption that
the case project is financed with the 20-year term loan.
However, the project is actually financed with the 10-year
PAGE 240
revolving line of credit.
The maximum borrowing amount is
$107 million with short-term floating interest rate of either
the prime rate or the LIBOR plus 7/8 %.
A question is why
the case project is actually financed with the revolving line
of credit, and what are the effects of this financing on the
project's value.
It is not known why, but one of possible reasons might
be that 1) the decision-maker expects the short-term interest
rate to drop to the levels of the short-term interest rates
in 1970's because the trend of the short-term interest rates'
decline from the beginning of 1980's is observed in 1985, 2)
the project is expected to generate cash inflows enough to
repay the interest and principal in early years.
are simply speculations.
But, these
The simulation is implemented by
using the actual financing terms, whose result is shown
below.
PAGE 241
Table 38 : Short-Term Financing
(000 U.S. Dollar at the end of 1985)
cash flow components
V.C.
--------------------------------U.S. partner
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
Economic ROI (%)
V.C. without tax-related components
(000 $)
-
-
Japan's partner
delayed tax
188
26,454
2,711
115
23,371
4,331
1,412
139
1,336
6,303
- 21,578
90,499
- 9,093
296
- 78,756
17,656
6,589
668
6,402
- 12,696
983
-
605
4.17
4,399
-
0.60
1,568
As is expected, the V.C. for both partners substantially
decrease mainly due to losing the advantages of the tax
shields on the interest payments.
Because the profitability
of the case project heavily depends on the tax shields,
especially for the capital partner, this is a natural result,
and this is a case which fits into the Tax-adjusted
Modigliani and Miller's Theorem on the capital structure.
In conclusion, the financing method of this case project
should have been selected by examining the V.C. structure of
the project, in addition to the other considerations such as
the term structure of the interest rates, and etc.
PAGE 242
2.4.7.
OPTIMAL COMPENSATION SCHEME
As was seen in this sub-section, the capital partner is
highly exposed to the unsystematic risks of the case project
and their tax positions.
The managing partner also desires
to increase the profitability of the case project, too.
A
question is whether or not it is possible for both partners
to get better off, by changing the structure of the case
project given in the beginning of this chapter.
There may be several solutions to the above question,
but one of feasible solutions may be to change the
compensation scheme given in the assumptions.
Because the
capital partner is not in a position of paying taxes for
coming 10 years, and because the managing partner can
currently take advantages of the tax shields, distributing
the accounting losses in the start of the project more to the
managing partner and distributing the operational cash flows
more to the capital partner could increase V.C. for both
partners.
The table below shows the result of the modified
compensation scheme, where both accounting and cash
distribution ratio is 85 (to the capital partner ) to 15
( to the managing partner ).
PAGE 243
Table 39
:
Optimal Compensation Scheme
(000 U.S. Dollar at the end of 1985)
cash flow components
V.C.
- -- - -- -- -- --
U.S. partner
equity contribution
gross income from operation
fixed charges
changes in working capital
debt service
salvage value
tax shield on depreciation
tax shield on amortization
tax shield on interest
income and capital gain tax
total
Economic ROI (%)
V.C. without tax-related components
(000 $)
-
-
- - - -
-
- - -
- -
--
- -
-
Japan's partner
delayed tax
188
16,239
1,626
185
14,335
2,598
2,498
254
4,265
5,913
- 21,578
105,112
- 10,305
905
- 91,842
20,010
6,152
621
10,917
- 13,246
3,607
4,935
24.84
2,503
4.35
491
The result indicates that the V.C. for both partner is
considerably increased.
However, in this modified
compensation scheme, the V.C. structure for both partners
also changed substantially.
First, the V.C for the managing partner without the taxrelated cash flow components decreases by $1,794,000, meaning
that the value of the project for the managing partner
shifted from the operational cash flows to the tax-related
cash flows.
However, the managing partner is better off
because he is in a position of being able to take advantages
of the tax shields.
Second, the V.C. for the capital partner without the
tax-related cash flow components increase by $2,595,000.
As
PAGE 244
a result, even if the capital partner can not turn into a
position of paying taxes over the project's periods, the V.C.
for the capital partner can be positive.
This a big change
from the original V.C. for the capital partner so that the
capital partner can lock in a better position independent of
the tax position and the degree of the diversification of the
portfolio which the capital partner holds.
In conclusion, the modified compensation scheme, where
both accounting and cash distribution ratio is 85
capital partner ) to 15
(to the
( to the managing partner ), could
improve both profitability to the capital and managing
partners, respectively, as seen in table 39, and reduce the
risks, by using the V.C. analysis, assuming that the tax
rates are not expected to change over the project duration.
PAGE 245
3.
CONCLUSION
The conclusions on this case analysis is as follows.
1) The base case V.C. analysis reveals that, although
the case project is acceptable, given the
assumptions, the project is marginally profitable,
and that the main cause of the value of the project
is the tax shields.
Therefore, the tax positions of
both partners seriously affect the value of the
project.
2) The managing partner successfully locked in a safe
position free from his tax position, and improved the
profitability by changing the probability
distributions of the returns, whereas the project is
not attractive enough for U.S. capital partner to
finance the project.
3) For Japan's capital partner, the case project is
attractive enough due to "international financing
effects".
However, the capital partner's value is
still heavily affected by the tax position.
In fact,
due to the inability to pay taxes, the value for the
capital partner is decreased.
4) The capital partner is also in a position vulnerable
to the unexpected changes in the operations or
unsystematic risks, such as the changes in the growth
rates, occupancy rates, depreciation schedule and so
PAGE 246
on.
5) The optimal compensation scheme could be found.
Modifying the compensation scheme could improve the
profitability and reduce risks for both partners,
especially for the capital partner.
6) The actual financing scheme hurt the value of the
project by losing the advantages of the tax shields.
The above conclusions are crucial both to the managing
partner's and capital partner's decision-making, and also to
the project organization, the structure, especially the
compensation scheme in terms of the risk and return tradeoffs.
Most of the conclusions would not have been discovered
by the other conventional or popular evaluation
methodologies.
This is why the "Valuation by Components" can
be the most effective evaluation methodology, especially for
those international projects which are more complicated than
domestic projects, but not limited to.
In next chapter, these conclusions will be elaborated
and implications and additional conclusions are drown and
discussed.
CHAPTER 6 : CONCLUSIONS AND RECOMMENDATIONS
PAGE 248
The purpose of the thesis is to examine the
applicability of the Valuation-by-Components with underlying
theories and concepts to evaluation of the international
investments, in the context of the construction and real
estate industries.
Through the examinations, the following
major points are found:
1) the ZCAPM is,
in practice, currently more applicable
to pricing the international assets than the CCAPM,
which has an issue of the theory to be clarified and
an issue of the consumption data quality;
2) investing in the foreign assets related to the
construction and real estate industries brings
benefits of international diversification both in the
long-term and short-term, whereas profit-taking from
the short-term investments in the foreign assets are
not necessarily expected;
3) given the imperfections in the current capital
markets, the firms engaged in the international
investments as well as the individual investors
should diversify away the unsystematic foreign
exchange risks, to some extent, with the firm's
portfolio diversification, whereas the systematic
foreign exchange risks and the rest of the
unsystematic foreign exchange risks can be hedged
with the optimal mix of operational and financial
hedging instruments;
4) the international financing should be always
PAGE 249
accompanied by the international diversification,
which motivates the investors to invest in foreign
projects which may not be undertaken by the domestic
investors, and diversify away the unsystematic risks;
and
5) the Valuation-by-Components is the best evaluation
methodology among others due to its theoretical
correctness, its transparency and flexibility to
accommodate the complexity of the structures of the
international projects, and its capability of
analyzing and allocating the relevant risks in
intelligible manners.
The following, in brief, summarizes and concludes the
thesis, and makes recommendations for further research areas.
1. PRACTICAL APPLICABILITIES OF ZCAPM AND CCAPM WITH
RELATED ISSUES
The Zero-Beta Capital Asset Pricing Model (ZCAPM) as an
international asset pricing model, in theory, employs the
world market portfolio so as to price the international
assets, assuming that the Purchasing Power Parity (PPP)
holds.
However, it is found that pragmatically applying the
ZCAPM to pricing the international assets faces difficulties
in defining and finding the appropriate world market
portfolio due to the current degree of integration of each
PAGE 250
segmented markets and the selection of the base currency unit
in converting assets denominated in other currencies.
Therefore, defining the appropriate world market portfolio
for the use of pricing the international assets must be
investigated further as well as the linkages between each
segmented market.
In the thesis, the modified ZCAPM, which employs the
theory for each segmented market portfolio, is found to be
more practically applicable to pricing the international
assets, though it is generally recognized to overestimate the
risks of the international assets.
As a further research,
incorporating the international assets, which have strong
linkages with each segmented market, to each segmented market
portfolio should be studied in order to adjust the pricings
of the modified ZCAPM.
The recommended research will be able
to price the international assets more adequately.
The CCAPM is theoretically superior to the ZCAPM because
of its capability of allowing the PPP not to hold, which is a
more realistic assumption than the PPP.
However, a
theoretical discrepancy between the CCAPM proposed by Breeden
and Stulz is found, which is left as a further research area.
The crucial issue in applying the CCAPM to pricing the assets
is the mismatching of the consumption data available and the
data which the theory requires.
The regression results
indicate the mismatching especially for the Breeden-CCAPM.
In this connection, as a further research, the consumption
-C
PAGE 251
data related to the utility functions should be clarified so
as to correspond to the actual data gathered, and at the same
time, the consumption data collection should increase the
accuracy by eliminating as many statistical errors as
possible.
Consequently, in the thesis, the Stulz-CCAPM is
applied to price the international assets.
The other important issue related both to the ZCAPM and
to the CCAPM is to identify the zero-beta portfolios for both
CAPMs, which was not implemented in the thesis.
Identifying
the correct zero-beta portfolios would explain the extremely
high historical rates of return on the zero-beta assets.
2. IMPLICATIONS OF ZCAPM AND CCAPM BETAS AND
REAL DISCOUNT RATES
The ZCAPM and CCAPM, which are formulated based on the
data of U.S. and Japan's construction and real estate
industries over the recent three years (1986-1988) are found
to reflect the current state of the economy, especially for
Japan, by comparing the results with those implemented by the
respectable precursors for longer periods of time ( about 30
years ).
The comparison reveals the dynamic movements of the
ZCAPM over the long periods, which necessitates
distinguishing the short-term and long-term investments in
pricing the assets.
Especially, for those assets which is
highly correlated with the segmented economic expansion, such
PAGE 252
as Japan's assets associated with the construction and real
estate industries, should be carefully treated in the shortterm and long-term.
In examining the calculated betas and real discount
rates based on the ZCAPM and CCAPM, the values of the
international investments are found not to be identical to
those who participate in the projects because of the
different risk determinants in different consumption patterns
and segmented economies.
In general, the investors who
invest in the international assets are found to benefit from
the diversification effects of the international investments,
which should promote the capital mobility across the borders.
In order to examine the CCAPM in the long-term, as a
further research, the long-term CCAPM should be tested by
employing the data for longer periods, which at least exceed
the business cycles of the nations' economies, with the
investigation on the theoretical and data-related issues
discussed earlier.
3. EFFECTS AND HEDGING OF FOREIGN EXCHANGE EXPOSURES
The foreign exchange risks (FX risks) inherent to the
international investments increase the variances of the
return on the international projects so highly that the FX
risks are found to have to be diversified away or hedged at
PAGE 253
the firm's level as well as the individual investors' levels,
given the imperfections in the current capital markets.
However, because this result can not be explained by the
modern finance theory, a theoretical justification is another
area for further investigations.
The FX risks relevant to the evaluation of the
international projects are, in theory, the systematic FX
risks, but not unsystematic FX risks which are caused by the
events and factors of unexpected nature.
The rationale
behind this is that the unsystematic FX risks can be
diversified away by holding the well- diversified portfolios
at the firm's level and the individual investor's level.
However, the systematic and unsystematic FX risks are not
easy to measure.
In this connection , methods of
distinguishing and measuring the systematic and unsystematic
FX risks should be pursued as a further research.
In this
thesis, the systematic FX risks are assumed to be reflected
in the market, such as the forward exchange rates and term
structure of interests.
The FX risks are grouped into two, one of which is the
FX risks associated with the unmatched amounts of foreign
cash flows at each point of time, and the other of which is
the FX risks associated with the relative price changes among
countries.
The contractual cash flows are primarily exposed
PAGE 254
to the former FX risks, and the non-contractual cash flows
are exposed chiefly to the latter FX risks.
The FX risks associated with the unmatched amounts of
foreign cash flows at each point of time are caused mainly by
the changes in the nominal exchange rates.
Those FX risks
can be hedged either by changing the markets of input
sourcing and output sales so as to reduce or eliminate the
unmatched amounts in foreign currencies
(the operational
hedging) or by generating the offsetting cash flows (the
financial hedging).
The FX risks associated with the relative price changes
among countries are caused by the changes in the real
exchange rates.
Those FX risks can be hedged by adjusting
the structure of input sourcing and markets to compete in, in
the long-term basis.
The general V.C. formula is proposed to conceptually
incorporate the FX risks as follows:
Valuation by Components
k
=
t * Ct * Dt * T
t=O
k
Bt * ( Xt + Yt + Zt )
2
=
* Dt * T
t=o
where Bt denotes an expected exchange rate vector
(1,n);
@t denotes an expected cash flow matrix
(m,n);
denotes an expected cash flow matrix
&t
PAGE 255
without FX hedging;
denotes an operational hedging cash flow
matrix (m.n);
Rt denotes a financial hedging cash flow
matrix (m,n);
Bt denotes a discount factor matrix (n,n);
and
'R denotes a unit vector (1,m)
Vt
The advantage of the proposed "matrix-type" V.C. formula is
its easiness of identifying and hedging the FX risks, its
separation of the FX hedging costs from the other cash flows,
and its potential possibilities of being applied to computer
programings.
Optimal solutions for the FX hedging could be
obtained with the Matrix-type V.C. formula by using the liner
programming, which is another area for research.
4. INTERNATIONAL FINANCING AND DIVERSIFICATION
The capital mobility across the borders benefits both
those who need the capital and those who provide the capital.
In this connection, the international financings
(or international investments) should be promoted.
However,
it does not necessarily mean that the international financing
or investments bring the riskless benefits.
The risks inherent to the international financings or
investments should be adequately analyzed and allocated in
reasonable manners.
Therefore, the risk hedging is essential
to the international projects.
Equivalently, the
international diversification should be always taken into
account in order to diversify away the unsystematic risks
PAGE 256
inherent to the international projects.
Thus, the risk-
hedgings and the international diversifications are
prerequisites to the international projects, which are often
poorly managed.
5. ADVANTAGES OF VALUATION-BY-COMPONENTS
The Valuation-by-Components is one of the best
evaluation methodologies among those currently available.
In
theory, the other evaluation methodologies such as IRR, NPV
and ANPV both with WACC, have drawbacks in their theories,
whereas the Valuation-by-Components and the Real Option
Approach are free from the theoretical drawbacks.
Given the
level of the developments in the current capital markets,
the Valuation-by-Components is more practically applicable
than the Real Option Approach which, though, has superior
theoretical characteristics to those of V.C.
The future
development of the capital markets and further applications
of the option pricing theory to the real asset pricing will
provide another promising area for research.
Also, the
international assets pricing models, including the ZCAPM and
CCAPM, which the V.C. employs, should be further developed
and tested as was discussed earlier.
In addition to the theoretical adequacy, the Valuationby-Components is capable of accommodating the complicated
structures of the international projects, such as the
PAGE 257
multiple-equityholders in
different consumption and risk
bases, multiple-currency financings, multiple-currency cash
flows in different risk-classes and so on with full
flexibility and transparency.
Among others, the Valuation-by-Components shows its
outstanding ability of analyzing and allocating all sorts of
risks associated with the international projects.
This
ability not only evaluates the projects in fair fashions to
all participants involved in the projects, but also
distributes the relevant risks to the participants so that
the optimal solutions could be reached in ways intelligible
to everyone.
This, in turn, would promote the capital
mobility across the borders.
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APPENDIX
Y
~r
i
PAGE 266
LIST OF APPENDICES
APP
1: CPI Index and Monthly Inflation Rate in U.S. and
Japan
APP
2: Nominal and Real Rates of Return on U.S. and
Japan's Market Portfolios
APP
3-1: Monthly Stock Price and Dividend of
Selected U.S. Firms
APP
3-2: Monthly Stock Price and Dividend of
Selected U.S. Firms
APP
4-1: Monthly Stock Price and Dividend of
Selected Japan's Firms
APP
4-2: Monthly Stock Price and Dividend of
Selected Japan's Firms
APP
5-1: Monthly Real Rate of Return of Selected U.S. and
Japan's Firms
APP
5-2: Monthly Real Rate of Return of Selected U.S. and
Japan's Firms
APP
6: Debt-to-Equity Ratio of Selected U.S. and
Japan's Firms
APP
7: Personal Consumption Expenditure and
Resident Population in U.S.
APP
8: Living Expenditure of All Japan's Household and
Persons per Households
APP
9: Seasonality Adjustment Factor of Japan's Consumption
APP 10: Changes in Real Consumption per Capita and
Consumption per Capita in U.S. and Japan
PAGE 267
APP 11: Monthly Data of Treasury Bill Rates, Representative
Money Market Rates, Effective Nominal Exchange Rates,
and Effective Real Exchange Rates
APP 12: Monthly Spot Exchange Rates and Estimated Equilibrium
Nominal Exchange Rates per IFE
APP 13: Term Structure of Interest of Treasury Notes in U.S.
and Japan and Estimated Monthly Inflation Rates
in Japan
APP 14: Polinomial Simulation of Term Structure of Interest
in U.S.
APP 15: Polinomial Simulation of Term Structure of Interest
in Japan
APP 16: V.C. Analysis Calculation Sheet for Base Case
PAGE 268
YEnA4ONTH
85-12
86-01
6 02
86-04
86-05
86086-07
86-0
8609
a6-10
86-11
86-12
87-01
87-02
7-04
o7-05
87-06
8707
87-09
87-10
87-11
87-12
86-01
86-02
86405
as-06
86-07
a8m
as-10
as-11
8 -12
APP
CP INDEX
US
JAPAN
132.70
115.40
13310
115.40
132 70
114.90
114.60
13210
131.80
11500
132.20
115.80
132.90
115.0
132.80
115.10
13310
114.90
13380
115s40
133.90
115.50
132.00
114.90
134.20
114.70
135.0
113.90
135.50
113.00
136.10
114.40
136.80
115.80
137.20
116.00
137.80
115.80
138.10
115.2
13890
115.
139.50
116.50
116.40
139.90
140.10
115.80
140.10
115.80
140,40
115.30
140.80
11510
141.40
115.60
142.10
116.10
142.60
116.20
143.20
116.00
143.80
115.80
144.50
116 10
145.40
117.10
145890
117.60
146.00
117.20
146.•0
116980
MONTI-Y
FLATDNRATE(%Y
U!
JAPAN
1: CPI Index and Monthly Inflation Rate
in U.S. and Japan
Sources:
International Monetary Fund, 1971-1989
PAGE 269
YEAR4MONTH
85-12
86-01
86-02
86-03
86-04
US MARKET
PORTFOLIO
--NOMINAL
RETURNS(%)
REAL
DIVDEND
CAPITAL
GAINTOTAL
RETUFITOTAL
RETURN
0.0467
0.0441
0.0016
0.0451
0.002
0.0046
0.0026
0.0024
0.0715
0.0528
0.0044
0.0761
0.0554
0.0013
0,0791
0.0603
0.0017
-0.0141
-0.0124
-0.0103
0.0047
0.0025
0.0018
0.0036
0.0502
0.0141
-0.0587
0.0712
0.0549
0.0166
-0.0569
0.0748
0.0517
0.0116
-0.0572
0.0729
0.0032
0.0009
0.0041
0.0019
0.0026
0.0044
0.0008
0.0027
0.0043
0.002
0.0016
0.0035
0.0022
0.0024
-0.0854
0.0547
0.0215
-00283
0.1318
0.0369
0.0264
-0.0115
0.006
0.0479
0.0482
0.035
-0.0242
-0.2176
-0.0822
0.0556
0.0256
-0.0264
0.1343
0.0413
0.0272
-0.0088
0.0103
0.0499
0.0498
0.0385
-0.022
-0.2152
-0.0867
0,0546
0.0247
-0.0273
0.1275
0.0373
0.0226
-0.0141
0.0073
0.0456
0.0476
0.0327
-0.0268
-0.2172
87-11
87-12
86-01
0.0034
-0.0853
-0.0819
-0.0832
0.0009
0.0023
0.0729
0.0404
0.0738
0.0427
0.0741
0.04
88-02
0.0052
0.0418
0.047
0.0443
88as0
88-04
0.0031
-0.0333
-0.0302
-0.344
0.0014
0.0046
0.0094
0.0032
0.0108
0.0078
0.0056
0.0044
86-06
86-07
86-09
86-10
86-11
86-12
87-01M
87-02
87.03
87-04
87-05
87-06
87-07
87-08
8710
87-1
as-05
8as-06
85.07
0.0031
0.0433
0.0464
0.042
0.0014
0.0055
0.0027
-0.0054
-0.0386
0.0397
-0.004
-0.0331
0.0424
-0.0082
-0.0372
0.0354
0.0239
86-10
85-11
0.0013
0.0026
0.0039
8 1-12
0.0047
-0.0189
-0.0142
-0.015
0.0034
0.0147
0.0181
0.0164
APP
.. .JAPAN MARKETPORTFO -O-----YEARMONTHTSENDEX
NOMINAL(%)
REAL
(YEN)
DIVDEND
CAPITAL
GAINTOTAL
RETUR TOTAL
RETUR.
85-12
1031.64
86.01
1034.39
0.92
0.30
1.22
1.22
86-02
1065.03
0.89
3.03
3.92
4.37
86-03
86-04
8605
86-06
86-07
8608.
86-0
86-10
86-11
86-12
87-01
87-02
87-03
87-04
87-05
87-06
8707
87-0
87-09
87-10
1162.99
1233.683
1264.45
1329,78
1394.76
1496.38
1503.96
1414.25
1432.66
1648.99
1742.31
1861.08
2050.98
2140.02
2171.44
1996.17
2101.60
2085.39
2023 68
0.83
0 79
0.76
0.73
0.73
0.72
0.78
0.76
0.73
0.73
0.71
0.70
0.65
0.63
0.60
0.55
0.55
0.52
0.52
0.53
9.10
6.09
2.48
.17
4,89
7.29
0.51
-5.96
1.30
8.43
6.15
5.66
6.24
10.80
4.34
1.47
-8.07
5.28
-0.77
-2.96
9.93
6.88
3.24
5.90
5.62
8.01
1.29
-S.21
2.03
9.16
6.86
6.36
6.89
11.43
4.94
2.02
-7.52
5.80
-0.25
-2.43
10.21
6.51
2.53
6.45
S.71
8.19
0.85
-5.30
2.56
9.35
7.61
6.36
6.43
10.08
4.76
2.14
-7.04
5.80
-1.36
-2.35
87-11
87-12
88-01
88-02
88-03
86-04
88-05
88606
18-07
88-08
8809
88-10
88-11
86 12
1852.26
1828.15
1828,36
1985.47
2109.32
2165.74
2167.79
2185.63
2177,78
2195.02
2124.77
2123.30
2217.24
2302.54
0,58
0.Sa
0.57
0.52
0.50
0.49
0.48
0.48
0.50
0.51
0.57
0.59
0.56
0.54
-8.47
-1.30
0.01
8.59
6.24
2.67
0.09
0.82
-0.36
0.79
-3.20
-0.07
4.42
3.85
-7.89
-0.72
0.58
9.11
6.74
3.16
0.57
1.30
0.14
1.30
-2.63
0.52
4.98
4.39
-7.41
-0.72
1.02
9.50
6,28
2.72
0.49
1.48
0.31
1.04
-3.46
0.09
5.34
4.66
1553.47
2: Nominal and Real Rates of Return on U.S. and
Japan's Market Portfolios
Sources:
Ibbotson Associates, 1989, and
Ministry of Finance,
1986-1989
PAGE 270
YEARUONTH
<<ADJUSTED
STOCK
PRICE.,
86
862
FluorDnel
15.75
13.
875
MorisonKnudsen
Foser Wheeler
CentexGeneral
Stone & Webster
39.75
13.125
24.5
45.5
51.5
CB8Industres
Turner
20.25
26.625
7.5
27.875
22
26.5
JacoebEngineeing
Perini
Californi REIT
Cenvill
FederalRealty
First Union
HoW Investment
HRE Properte
IRT Propertets
Saul B F RL Ihv
12.375
15.875
17.375
25.75
20.625
Mt
16.375
17.625
18.25
13 875
4375
14
29
7
29.875
13
18.25
17.875
28.875
21.125
863
17
16.375
48.375
14.875
31.75
56.75
22.5
28.5
6.625
33
12.625
18.75
19.25
30.625
22.875
nMi
16.25
17.5
19
87
87-2
86-4
17.25
17.125
49.25
1325
32.125
50.125
875
24.
27.125
8.25
30.125
13
18.25
1875
29 875
22.75
25
19.75
17.5
865
18 375
16.875
51.375
13.875
33.25
49
26.25
26.25
9.5
31.375
11.25
18.25
18.5
866
16.25
14.25
46.75
13.5
34.625
S0.5
24 875
26.625
9.375
31
10.75
20.75
22.25
23.5
19.875
18.125
20
22.5
23.5
25.375
20.5
17.375
15 625
86-7
a6-8
13
13
14.5
14.5
42
45.375
12.25
34.25
92.125
28.9875
22.375
11.875
30.25
47.75
26.25
24.875
8.25
28.625
11
18.125
20.75
23.5
22.25
25.375
18.625
26.5
12
22.125
25
22.625
25.375
19.5
18.75
86-9
12.875
14.25
43
11.25
37.5
51.75
26.125
22.375
7.5
27.125
11.5
18 625
19.625
24.5
20.375
24.875
MA
19
8610
8611
12.125
14.875
43.375
13.25
34.375
51.625
26.5
22
8.75
28.875
12
12.375
19
20
25.75
22.375
24.675
17.875
17.25
15.875
43
13
36.5
51.5
24.875
21.625
9.5
27.625
12.25
19
19.25
25.75
22.875
26
16.625
17.25
<STOCKDIVIDENOS..
Flur Dan~
CRSS
Morns• Knudsen
Fos•er Weeler
Cetex Geneal
Stone & Websete
CB1Indutres
Turner
Jaobrb Engineering
Perini
California
REIT
Cenvill
FederalRealty
First
Union
Hoa Investment
HRE Propereti
IRT Propertei
Saul B F RL Inv
YEARMONT9H
.ADJUSTED
STOCK
PRICE>>
FluorDaniel
MorrimnKnudsen
Foster Wleeler
CentexGeneral
Stone & Webster
C81 Indualie
Turner
Jacoa Engineenring
Perini
8612
11.5
14.375
42.25
13.125
31.25
49.125
26.875
20.625
28
13
17.5
53
17
30.75
53.25
32
24
9
30,75
Californi REIT
Cenvill
11.375
7.375
18.875
FederalRealty
19.875
First WUio
HoWsInvestnt
HRE Properses
IRTPropaertes
25
22.25
26.75
16.375
20.125
22.875
25.375
22.875
26.125
18.125
SaulB F RLhv
16.5
17
15.375
16.25
50.125
17
56.5
30
26
10.125
32.5
7.25
20.29
23.875
25.5
24
27
19
16.875
87-3
87-4
16
14.75
19.125
17.125
19.75
48.25
15.25
30.5
55.125
30.875
27.75
10
32.25
47.625
49.625
16
33.125
53.5
27.875
27.375
10.125
32.5
7.25
20.5
23.5
25.25
24.75
23.625
19.5
17
6
21.375
23.25
26.25
23.375
23.5
18.625
17.125
87-
19.5
27
59
29.625
23.5
9.75
29.625
6.5
20.375
21.875
26.625
21.375
23.625
18
14.7S
8746
17.625
24.75
49.125
20.29
26.75
68.375
30
26
10.125
31
6.25
20.75
23.25
27.125
22.875
23
8777
19.875
24.625
54.5
22
28.25
74.5
28.25
24.25
16
31.75
6.129
19.75
198.375
22.125
26.75
21.375
22.75
18.75
16.375
17.375
87-
87-9
19.125
19.375
15.625
52.75
22
27.25
86.875
30
25
14.625
15
51.25
21.625
24.875
86.25
28.25
31.125
31.875
6.5
19.875
22
25.5
6.25
19.875
22
25.375
20
20.375
18.95
18.75
21.125
21.125
18.375
18.375
25.S
14.25
8710
14.5
11.5
33.5
13.125
16.75
60.625
20.375
17.5
13.375
22.875
5.25
18.125
19
18.375
15.75
18.375
13.625
16.75
A-STOCK
DK1DENCIS,.
FluorDniel
CRS
Moison Knudsen
FoamaVe.ea.
Cetex Geeral
Stone & Webster
CBIInduslres
Turner
Jcobs Engineeraning
Perini
Califrnil REIT
Cenill
Federal Realty
Firlt Union
Hotel Inve&snent
HRE Propetea
NIT Properties
SoulBF RLIn
0.01
0.02
0.12
0.04
0.02
0.15
0.09
0.11
0.00
0.08
0.05
0.18
0.09
0.06
0.17
0.16
0.11
0.02
APP 3-1:Monthly Stock Price and Dividend of Selected US Firms
Sources: Daily Stock Price Record, 1986-1989,
Morgan Stanley, 1986-1989,
Moody's Handbook of Common Stock, 1986-1989,
Moody's Annual Dividend Handbook, 1986-1989
PAGE 271
YEARMONTH
-ADJUSTEDSTOCK
PRIKEl
Flur Danel
CRSS
Morrise Knudsen
Cenex General
Stone & Webser
C81 Industres
Turner
JeoEbs Engiering
Perini
Californi REIT
Cenvill
Federal Realty
Firm lion
Hote Iroetm'ent
HRE Propente
RT Propries
SaulB F RL Inv
Eniel
87-11
12
12
32.25
10.875
16.5
58
19.25
16.625
14.625
21.375
5.25
17.S
87-12
1375
12
33.25
13.75
17.25
67.5
19.875
16.125
17.75
24.75
4.5
17
18.375
19.
875
18
18 125
15.5
19.5
15.25
21.125
15.
875
17
14.375
16.125
88
13.25
12.375
32.125
14.5
17.125
68.25
20.625
15.875
16575
25.25
6.25
18.875
19.5
21.75
15.375
22.5
15.375
17.875
0.01
0.02
0.12
0.04
0.02
0.15
0.05
0.11
001
0.02
0.08
HoW Irestment
HRE Prope~ba
IRT Properties
Saul F RL hv4
0.00
0.08
0.05
0.18
0M08
0.06
0.17
0 16
0 11
0.02
0.02
0.18
0.10
0.07
0.17
0.15
0.12
0.01
YEARAiH
88-10
55'
88&12
Fluow
Mornmon
Knudsen
Foemi WheeleSr
Centex General
Stone & Webaer
CBIIndustries
Turner
Perni
Califoria REIT
Cenvill
FederalRealty
Firs Union
0.12
0.04
0 02
015
0 05
0.11
0.05
0 .18
0.09
0 06
017
016
0 11
0.02
0.02
0.12
0.04
0.02
0.20
0.05
0.11
0.00
0 18
0.04
88 2
88 3
17.25
1825
16.625
18
17.25
37.25
13.125
2025
69 125
27.625
16.375
16.625
27.875
5.375
19.5
20 125
21.125
3575
15.25
35.875
14 75
21.S5
72
24
15.875
16.625
26.375
S.625
18.75
21
22.75
16.5
24
15.875
17.5
0.02
0 02
0.12
0.04
0.02
0.20
0.05
0.11
0.00
0.18
0.04
0.18
0.10
0.07
0.17
0.15
0012
0.01
16.5
22.75
16 125
88-4
12
22.25
70
28
15
15.875
26
5.25
18.5
21
21.75
16
23.375
15.875
17.5
17.25
0.02
0.02
0.02
0.12
0 04
0.02
0.20
0.05
0.11
0.02
0.00
0.18
0.04
0.18
0.10
0.07
0.00
0 18
0.04
0.17
0.15
0,12
0.01
0.12
0.04
0.02
0.20
0.05
0.11
0.18
0 10
0.07
0.17
0.15
0.12
0.01
a8
5
88 6
18
21.5
23.25
41.25
16.625
27
67.25
30.625
19.75
17.25
37
13.375
26.5
64,375
28
15.5
15.625
27.25
5.125
18.25
20.625
22.125
15 375
22.75
15.625
16.5
0.02
0.02
0.12
0.04
0.02
0.20
0.05
0.00
0.18
0.04
0.18
0.10
0.07
0.17
0.15
0.12
0.01
19.125
29
5.375
18.375
20.875
19.875
15.5
23.125
18
24
8-7
88-8
88-9
22.25
21.25
21
23.375
38.75
15.25
29
21.75
20.5
41.875
15.5
27.625
68
29.75
20.25
23.125
39.5
29.25
5
18
20.5
20
14.75
22.75
17.5
27.875
0.02
0.02
0.12
0.04
0.02
0.20
0.05
0.1 1
0.00
0.18
0.04
0.18
0.10
0.07
0.02
0.02
0.12
0.04
0.02
0.20
0.05
0.17
0.15
0.12
0.01
0.17
0.15
0.12
0.01
0.11
0.00
0.18
0.04
0.18
0.10
0.07
15.875
27.375
69
28.375
20
19.75
31.375
4.75
17.5
20.75
18.625
13.875
24.375
18.25
70.625
27.5
18
19.75
33.5
4.875
17
20.625
18.625
11.75
24.375
18
0.02
0.02
0.12
0.04
0.02
0.20
0.05
0.11
0.02
0.02
0.12
0.04
0.02
0.00
0.18
0.04
0.18
0.10
0.07
0.17
0.15
0.12
0.01
0.00
0.18
0.04
0.18
0.10
0.07
0.20
0.05
0.11
0.17
0.15
0.12
0.01
.ADoJJ.TE)STOCKPRKE..
Fluor Dani
CRSS
MorrismKnudaen
Foer Wheeler
Cel.e• General
Stone & Webeler
CBIlrndualte
Turner
Jaobs Engineerng
Perini
California REIT
Cer ill
Fedenl Realty
Firs LUnion
HoW6hwesmen6t
HRE Pmperies
RT Propertes
SaulO F RLIvw
Fluo Daniel
CRSS
Morrison Knudsen,
FoewrWheeler
Canbt Genral
Stne & Websler
CBIIndus
Turner
Jamb, Engineeranng
Perni
Califomia
RE IT
Cevill
FederalRealty
Firl Unim,
HOd h5ve0sent
HREProperss
IRTPropertes
SaulB F RLInv
19.625
23.125
37.125
14.375
27.375
73.25
28
16.5
20.625
35.5
5.5
16.625
20.5
18.625
10
25. 625
18.125
20 5
24.125
37.375
13.375
26
70.75
26.25
16.5
22.25
32.75
6.25
16.375
20.5
17.675
9.375
25.5
nII
23.375
26.5
39.375
14.5
29.25
69.875
25.375
16.75
23
32
5.75
15.625
21.125
18.25
9.25
21.5
18.5
na
0.02
0.02
0 02
0.02
0.12
0.04
0.02
0.20
0.05
0.11
0.00
0.18
0.04
0.18
0.10
0.07
0.17
0.15
0.12
0.01
0.12
0.04
0.02
0.20
0.05
0.11
0.00
0.18
0.04
0.18
0.10
0.07
0.17
0.15
0.12
0.01
0.02
0.02
0.12
0.04
0.02
0.20
0.05
0.11
0.00
0.18
0.04
0.18
0.10
0.07
0.17
0.15
0.12
0.01
APP 3-2:Monthly Stock Price and Dividend of Selected US Firms
Sources: Daily Stock Price Record, 1986-1989,
Morgan Stanley, 1986-1989,
Moody's Handbook of Common Stock, 1986-1989,
Moody's Annual Dividend Handbook, 1986-1989
PAGE 272
YEAR-MONTH
61
86-2
863
864
86-5
864
867
868
868
86 10
8611
685
411
485
380
485
770
774
372
384
386
326
n/l
1090
1010
n/9
720
482
550
775
668
850
750
565
825
759
625
s85
736
666
860
756
708
930
772
788
1200
855
775
1300
730
635
1010
759
718
1190
446
S80
854
848
425
395
420
371
N/
435
830
820
8
642
54
554
485
noi
415
723
820
8
53S
6555
588
450
n/3
4I
462
875
833
595
622
580
s509
449
910
834
888
665
660
590
568
471
1000
870
868
765
675
815
s8
nM
494
1300
890
965
950
770
744
850
2940
580
1480
1280
1090
939
735
825
1010
2890
481
1120
1070
940
787
666
683
828
2890
483
1200
835
1020
850
718
719
848
3350
2250
1850
1590
SPRICE
.LJUJSTEDSTOCK
AokiConstruction
Caorp
Fujrit
Hanreo
Hazema-Gumi
Kajima
Kumogli-Gumi
MaedaCorp
Cop
Ohbuyashi
i
Pe
OceaeCn3b5ucton
Shimizu
Constructon
TaisiCorp
Daikyo
Eutai
UMi•ubishi
Rel Estale
Mitlui
& Dev
SumionoReally
816
9,
1270
1130
1310
2230
1780
1710
1750
1600
1450
2030
1690
1480
2090
1890
1530
2220
2000
1590
2270
1930
1500
2770
2150
1560
2170
1810
1240
0.62
0.46
0.92
0.50
0.68
0.64
0.75
0.62
0.46
0.92
0.50
.6a8 .6
0.64
0.75
0.62
0.46
0.92
0.50
0.68
0.64
0.75
0.62
0.46
0.92
0.50
0.68
0.64
0.75
0.62
0.46
0.92
0.50
0.68
0.64
0.75
0.62
0.46
0.92
0.50
0.68
0.64
0.75
0.62
0,46
0.92
0.62
0.46
0.92
0.62
0.46
0.92
0.62
0.46
0.92
0.50
0.68
0.64
0.75
0.50
0.68
0.64
0.75
0.50
0.68
0.64
0.75
0.50
0.68
0.64
0.75
.cSTOCK
DNIDENDS>
AokiConstruction
Corp
Fujpla
Haseko
Hazuesulmi
Kajiml
KIumagai-Gumi
MaedaCop
OMiyubhiECrp
Pab
tsOean Canstctio
Construction
Shimizu
Caorp
iaime
0.62
0.46
0.92
0.50
0.6
0.64
0.75
0.46
0.25
0.75
0.58
Estm
Mitsubiahi
RealEseal
uMiui
SumitomoReally Dev6
0 55
0.58
YEAROHNTH
86-12
0.46
0.2S
0.75
0.5
0.46
0.25
0.75
0.58
0.46
0.25
0.75
0.56
0.46
0.25
0.75
0.58
0.46
0.25
0.75
0.58
0.46
0.25
0.75
0.58
0.46
0.25
0.75
0.58
0.46
0.25
0.75
0.58
0.46
0.25
0.75
0.58
0.46
0.25
0.75
0.58
0.55
0.58
0.8
0.68
0.55
0.58
0.68
0.55
0.58
0.68
0.55
0.58
0.68
0.55
0.58
0.68
0.55
0.58
0.6
0.55
0.58
0.55
0.58
0.68
0.85
0.58
068
0.55
0.58
0.68
87-2
87.
87-4
87-!
874
87.7
8748
874
851
734
1300
542
867
795
1440
665
900
826
1370
707
1140
871
1660
691
87-1
0.68
87-10
PRICESo
STOCK
eAdJJSIIED
AohiConsruction
FujitCorp
HaDako
830
685
1120
490
880
740
1180
566
980
937
994
1080
1010
672
1350
864
1640
1000
1410
973
838
900
728
1330
685
1780
1090
720
1220
710
712
1120
735
1730
1810
1030
1000
1590
1030
910
1030
1540
1010
1720
1130
880
1010
860
1010
1460
1550
1570
1660
1950
1950
Kumagai-Gumi
Maed6CaVp
Ol8bepyshiCop
Pea Ola n Coalbru¢om
Shimizu
Cotrution
Team Carp
1180
976
911
711
740
910
1200
1190
1070
904
980
1160
1120
1050
763
990
1030
1320
1160
1240
820
106S
1100
1200
1610
1210
970
1170
1220
1210
1600
1170
983
1030
765
1380
676
1630
1030
1390
996
835
914
1240
1020
999
1040
1050
1070
DaiyoM
Etlate
Mitubilsi
RealEeta
Mitsli
3420
2490
1890
3570
2720
2100
3830
2700
2170
3570
3300
2500
3270
3110
2530
4380
3040
3020
3900
2700
2280
4060
2520
2250
4150
2620
2320
3700
2510
2120
3300
2250
1900
Sumitno Ra•lty Dev
15890
1610
1530
1800
1890
1900
1610
1450
1540
1490
1310
Ao Calsructiona
Fujit Corp
HtekO
0.82
0.46
0.92
0
0.46
0.92
Hazme-Guni
Kajiml
0.50
0.50
0.68
Kumlllagali-Gumi
MLedaCorp
O
8)eNlhi
Corp
Pota (OeanCoge•uctan
Shimiz6,
C•nntrucion
0.64
0.75
0.46
0.25
0.75
0.68
0.64
0.75
0.46
0.25
0.75
TalieCorp
0.58
Dlikyo
0.81
Etatle
Mitsubihi
0.55
Mitsui
Real Eltab
0.58
0.58
a Dev
Sumitwo Realty
0.68
0.68
Haazm-Cbumi
Kajima
.SrTOCKDW I
800
o,
0.67
0.67
0.50
0.92
0.50
0.82
0.50
0.50
0.50
0.71
0.67
0.75
0.50
0.25
0.75
071
0.67
0.75
0.50
0.25
0.75
0.71
0.67
0.75
0.50
0.25
0.75
0.58
0.58
0.58
0.99
0.99
0.46
0.92
0.50
0.82
0.50
0.92
0.50
0.92
0.50
0.82
0 7
0.50
0.92
0.50
0.50
0.50
0.50
0.50
0.50
0.68
0.64
0.75
0.46
0.25
0.75
0.68
0.64
0.75
0.46
0.25
0.75
0.71
0.67
0.75
0.50
0.25
0.75
0.71
0.67
0.75
0.50
0.25
0.75
0.71
0.67
0.75
0.50
0.25
0.75
0.71
0.67
0.75
0.50
0.25
0.75
0.58
0.5
0.58
0.58
0.58
0.58
0.81
o.81
0.81
0.99
099
0.99
0.55
0.55
0.58
0.68
0.55
0.57
0.57
0.57
0.57
0.57
0.57
0.57
0.58
0.64
0.64
0.64
0.64
0.64
0.64
0.64
0.68
0.75
0.75
0.75
0.75
0.75
0.75
0.75
0.46
0.82
0.87
0.67
0.762
0.62
.62
0.7
0.67
.67
0.6
0.99
099
APP 4-1:Monthly Stock Price and Dividend of
Selected Japan's Firms
Sources: Wall Street Journal, 1986-1989,
Morgan Stanley, 1986-1989,
Moody's Handbook of Common Stock, 1986-1989,
Moody's Annual Dividend Handbook, 1986-1989
PAGE 273
YEAR4MONTH
87.11
8712
88
8 2
883
864
M5
864
88-7
884
8e4
,.ADlJSTED STOCK
PRICESAudi Coniuction
Fujio Corp
Hu00*
Hlrma.Gumi
Kljims
Kumagai-Gumi
Maed' Corp
Ohbaeeshi Cop
Pean OQan Comnswrucetm
Shimizu Constru~eo
Taise Cup
Mitsubishi Estel
MitluiReld Eese
SumitomoReatly& Dev
*STOCKOC
ENNDS,
Aoi Cbstruction
Fujiul Corp
HameM-Gumi
Kojims
Kumangi-Gumi
Meds Corp
Ohbyashi Cop
Pentl Oan Castrucw
Shimiuj Contrucin
Taisi Corp
Mitsubishi Estam
Mitsui Rel Etols
Sumieno Realty a Dev
VEAR-MONTH
-10
868-11
88-12
AdDJUlIED
STOCK
PRICESn
Ai Constructian
FujiI Coap
Hmzlm4numi
Kajims
Kumaged-Gumi
Man C up
Peni Qoan C•nsucban
ShnimiuConstructio
Tissi Corp
Daikyo
MitsubishiEests
Mitsui Rel Estste
SumitomoRemityI Dev
Adi Constuctan
Kumgm-Gumi
Mede Corp
Othbyashi Cwp
Penes Oean Coultuccam
SNminu Constru-bon
TaimeCop
Deikyo
MitsubishiEstlit
MitsuiReel Emst
SumitnmoReally
8 Oev
APP 4-2: Monthly Stock Price and Dividend of
Selected Japan's Firms
Sources: Wall Street Journal, 1986-1989,
Morgan Stanley, 1986-1989,
Moody's Handbook of Common Stock, 1986-1989,
Moody's Annual Dividend Handbook, 1986-1989
PAGE 274
86-
YEAR-MONTH
8-2
863
rki
hia
nMI
ni
nIA
n8
nIN
S
nMil
ni
9.22
18.81
0.44
16.43
7.27
-6.39
10.71
7.74
13.82
0.24
6.23
16.36
3.69
12.69
3.54
n
0.35
-0.32
2.97
10.05
18.69
-6.24
7.00
-4.93
11.36
11.19
10.95
8.45
-1.62
4.12
8.67
6.73
9.57
nA
18.28
3.42
neI
nO
NO
ne
na
ni
ni
11
nr
nm
ni
Rn
n11
rhi
nMI
S.66
17.90
14.09
18.01
2025
11.47
10.13
14.87
3.38
1546
14.48
n
17.07
12.43
n1i
8.01
39.05
55.12
-2.10
43.60
-3.66
4.73
51.56
37.30
32.43
31.23
86-4
865
866
11.03
1.48
4.93
1.90
-10.47
24.81
2.30
-8.30
-11.24
-4.23
4.05
-1.55
-1.92
-2.05
0.41
nM
M
4.89
-2.46
S.41
3.25
-1.65
6.39
4.68
14.80
4.25
4.06
-2.28
-3.12
-12.91
0.61
-1.17
-30.57
-1.76
-5.53
1.00
-0.92
-5.55
3.65
-15.89
-11.85
2.959
-1.84
9.24
1.50
-3.48
-15.64
-3.17
-4.81
1311
-0.27
-8.03
-1688
2.28
9.90
-7.42
n)
i
-21.77
-10.39
-15.46
0.58
9.94
3.03
10.68
20.28
0.96
7.19
10.53
11.34
-1.92
12.46
nrut
15.23
4.93
1.41
86 7
86-8
86-9
8610
8611
10.02
13.12
11.52
11.62
3.31
-3.18
8 17
-7.33
9.28
9.75
9.90
0.08
6.89
645
2.28
0.60
n4m
0.61
-9.82
8.98
-2.11
-11.45
-8.34
-6.74
5.46
2.07
-0.99
-0.04
-3.78
3.85
-11.37
-2.30
-9.68
-1.74
M
n
0.89
1.55
-8.35
4.44
-5.64
18.02
16.58
1.08
6.62
-0.06
-1.27
,520
2.83
2.28
5.24
0.55
0.69
n
-9.19
-6.01
6.16
6.77
2.26
-1.68
8.49
-0.66
-4.17
-0.06
-1.29
2.90
0.80
-3.38
0.14
2.90
5.21
-6.32
0.02
2.38
11.56
29.36
5.17
30.29
2.55
11.46
24.46
14.31
21.31
42.49
nia
2.45
-3.30
5.45
10.35
-2.02
7.94
17.00
13.40
43.27
12.54
-1.54
-4.93
10.51
18.38
-2.10
21.52
10.95
3.59
-14.62
-18.08
-22.30
-17.05
-24.34
-16.43
-13.77
-16.21
-9.43
-17.19
-18.03
-0.06
-21.71
-25.15
-20.54
4.60
13.73
18.53
1.04
7.76
-21.96
9.16
8.63
8.41
S.93
2.78
16.55
4.25
15.54
28.95
.<MAL RATEOFRETU3N>
nR
n/a
CBI Industrie
CentexCGenael
MA
CRSS
Fluor Dani
Foster 90888
nMI
MnI
ni
nMI
Jacobs Engineering
Morion Knudsen
Perini
Sto•e & Webalor
Turner
California REIT
Cenvill
rul
Federal Realty
First Union
HoW hnvestment
HRE Properes
IRT Propertes
Saul B F RLIhv
Aoki Construclion
Fujita Corp
Huwko
HazamLa-Gumir
Kajima
Kumagai-Gumi
MUdi Corp
OhbmayshiCoap
Pna
Oemn Co•eraucon
Shimizu Construction
Taiws Cap
Daikyo
Mitsubishi Estatb
MitsuiReal Esltae
Sumitomo Realty£ Dev
YEAR4ADNTH
86-12
87-
I
n
76.09
57.99
30.93
"
87-2
87-3
87-4
2.79
1.30
-4.00
-0.30
8.01
8.12
5.81
8.21
3.27
6.73
-2 44
7.19
1.22
-2.20
4.62
0.72
1.52
12.43
6.70
2.38
12.29
3.52
12.45
3.96
87-5
5.73
-12.57
8.64
-19 .80
11.76
12.00
-9.90
7.45
-5.18
-6.17
3.32
0.92
4 19
4.69
-4.61
0.75
0.09
2.89
6.47
8 34
5.10
10.06
4.48
-2.08
15.21
2.40
4.46
5.48
6.34
5.94
4.06
876
7-7
87-8
87-9
87-10
dEALKRATEaF RETURIA
CBIIndustries
Cenx Generll
CRSS
Fluo Danie
Jacobs Engineing
Morans Knudaen
Perini
Smtie & Weabser
Turner
CaliforniaREIT
Ceonvill
FederalRealty
First Unionm
HoW
hIReinent
HRE Properes
IRTPropertes
Sal B F FRL
hv
Aoki Construction
Fujita Corp
Haeeko
Hums-Gumi
Kajim
Kumagai-Gumi
MasSaCorp
Ohb, yaai Cap
Peta Ocean Cmstrucr0o
Shimiru Cortructon
Taisei
Corp
6
D ikyo
Mitsubishi Eslta
MUi'tuReal Estate
Sumitomo Realty & De
APP
16.11
-14.45
-9.46
-6.94
10.34
-2.12
21.15
12.44
-6.44
15.09
-7.38
17.89
7.33
-7.04
10.40
3.66
10.37
-8.33
5.81
-8 23
-4.17
-11.66
3.07
15,82
0.99
-1.28
24.87
2.52
-5,87
5.46
-0.64
12.57
5.76
-4.02
nri
-4.29
-6.07
1.10
5 40
1.60
29.04
-0. 59
24.99
-0.15
12.08
-5.54
-6.08
-044
-1. 19
9.47
8.06
16.19
-35.08
6.91
14.87
1.15
2.94
-2.32
10.84
2.52
S.57
5.99
8.38
-1.34
1.12
4.39
0.37
5.26
3.58
5.17
-1.00
-0.18
27.74
-2.78
-1.33
-8.15
6.99
-15.17
3.58
3.39
2.96
4.47
15.64
10.61
8.59
57.68
10.95
2.47
8.94
-6.52
-0.41
-9.12
.3.54
-2.27
16.14
2.94
-1.96
1.45
-4.50
-4.27
-6.41
0.07
3.55
-2.85
-2.15
3.46
-0.85
-4.39
-4.95
-1.74
-3.02
-1.02
2.79
1.24
-3.45
-1.36
6.38
-3,44
0.45
9.63
-4.37
5.64
1.73
21.94
41.32
6.85
8.86
6.18
16.22
6.96
2.47
-3.22
-0.74
10.25
-3.98
1.34
-3.28
-4.07
7.42
-0.77
22.86
18.33
13.34
-5.82
-1.82
-4.59
1.51
7,91
10.36
22.25
5.32
13.35
3.19
17.63
7.03
3.20
7.82
2.29
10.88
2.37
0.22
23.12
8.51
5.15
10.03
11.93
2.01
9.60
5 16
7.31
-0.71
3.36
-4.93
5.67
6.39
7.17
21.71
14.73
17 18
-5.46
5.24
0.29
1.65
-1.62
-1.17
3.36
-12.30
2.88
0.39
-9.03
-27.91
-32.77
-4.29
-23.43
0.91
4.58
-4.14
2.25
-4.18
0.93
-1.18
3.68
-5.37
-5.79
1.38
-8,11
6.24
1.67
7.33
-4.65
-1.36
-6.03
-0.72
-4.98
-0.96
-0.01
-0.67
-4.95
-25.33
-39.31
-6.41
-34.58
-28.18
-29.74
-31.15
-15.39
-8.19
-13.46
-27.54
-20.64
-0.36
-4.30
0.92
-2.92
-2.40
7.91
-0.61
-2.75
-6.98
-1.86
0.32
-14.02
10.65
5.98
5.24
-3.21
0.97
1.69
-25.84
-10.83
2.63
2.71
-5.95
5.10
16.09
-1014
37.18
-3.56
16.89
10.15
9.62
-9.48
-6.88
0,00
3.77
26.52
5.33
21.03
-2.36
-0 14
0.72
-0.75
-3.43
1.19
-12.05
1.51
33.74
-2.40
19.19
0.39
-3.82
-11.63
-1.60
1.19
1.18
-2.34
2.02
-1.75
0.91
0.94
-1.49
4.67
6 .16
-0.77
-9.43
6 15
8.41
-1.41
4.74
8.58
8.07
12.82
5.91
8.62
14.53
4.16
2.24
3.99
3.14
6.25
-16.93
8.90
-13.83
-11 96
-16.67
-1. 93
-16.23
-14.67
-12.93
-14.60
-14.88
-11.04
-17.55
-10.78
-11.01
-24.35
-15.08
-2.98
-3.03
2.24
-0.97
1.99
7.S1
-2.13
-9.23
1.09
-3.85
-5.63
-4.18
-2.99
-4.35
-2.96
-0.11
-11.81
-5.25
-9 61
4.28
-9.29
-6.34
-0.96
-8.04
3.68
4.76
-2.76
11.83
12.03
-2.16
0.16
2.05
-10.71
-10.26
-10.27
-11.96
5-1: Monthly Real Rate of Return of Selected U.S. and
Japan's Firms
(Calculated by the Author)
PAGE 275
YEARMONTH
8711
87 12
5 41
1I 51
3.51
a8
88 2
as
3
884
16.27
25.31
23.04
29.95
1.69
14.82
.6.12
8.68
5.45
-11.14
-0.42
3.73
1 04
9.44
3.37
-1.76
-8.74
-4.98
-4.17
-5
5-6
7
8
83-9
<<REAL
RATEOFRETUIRN>
Cal Industres
Cenex General
CRSS
4.67
4.36
-17.30
16.98
9.19
-3.50
-6.32
-4 22
-4.52
0.87
-262
-294
Fou
l
REgT
.me
Engineering
Jacobs
Morrison Knudsen
Peral
L•
Stone
WebsWtme
Turner
Calilorni RE IT
Cenvill
Realty
Federal
Firlt Lnion
Hotl
CInves1en"t
HIREPmopees
IRTProperties
Sul B F RL bv
-1.83
-0.67
6.84
6 .33
3.77
on
Aoki Conirtct
Fujita Corp
Haauko
Hazrn -G•ni
i
Kajiml
Kumia i-Gunmi
&o
C
Mgdae
OC1ayahi Carp
Per Ocean Cnmiruct0en
Shimizu Conltruct'o
Toie. Corp
Daikyo
Mitsubihi Esate
Mitui Real Esatl
Sumitnro Really& Dev
-3.40
-3.51
-2.99
-0.10
-7.22
-9.47
-9.37
-10.11
-4.01
-4.26
-6.47
-4.93
-8.39
7.38
13.24
810
YEAR-MONTH
0.16
14.65
26.78
-1.03
11.74
21.37
3.48
16.16
16 64
-2.36
13.27
.1.66
8.67
5.49
0.39
-9.66
0.02
7.91
4.63
8.09
7.03
3.862
-2.31
1.05
-0.54
9.15
11.36
5.53
5 36
6.41
3.02
-4.76
0.86
1.77
6.91
5.70
-0.72
-10 10
-7.33
-20.92
-9 37
-16.08
14 80
A
5.50
8.09
4 84
7.28
8.76
14.49
-17.53
-2.21
-20.95
14.25
- 11.8
88-11
10.52
11.7301
15.73
8.91
-4.12
3.39
-4.19
4.53
-4.09
7.22
0.58
-4.99
1.98
-0.35
-6.56
1.0o
-8.19
-2.11
-4.66
4.34
2.79
-2.50
2.90
-1.21
-1.84
1.01
3.48
1.70
1.87
-2.57
-0.8
-2987
-0.52
2.44
2.07
-2.63
13.45
-9.01
3.45
0.00
3.15
1.21
4.66
-0.07
4.86
12.81
3.28
0.04
-3.23
3.39
3.42
2.59
-0.41
-1.35
-2.52
9.09
1.54
34.33
19.04
24.05
21.89
11.35
6.62
4.34
27.58
5.17
1.26
1.28
-10.22
1.47
1.88
15.57
44.92
5.27
-1.61
3.18
-6.45
-4.37
1.25
-4.82
-3.09
-0.89
0.25
-1.26
-1.53
-4.21
-9.24
-5.54
-4.92
1.31
-6.11
3.51
5.36
13.42
-4.88
2.16
-1.71
-4.30
-1 S.01
-0.62
-5.84
-2.20
7.35
1.27
-1.18
-4.71
2.24
6 67
2.01
-10.02
2.78
-2.42
1.23
-0.73
-8.97
-5.26
7.26
4.54
-0.24
-14.65
-0.01
-1.25
-S.81
-4.20
1.38
3.41
1.03
-3.33
-3.20
5.15
-1.63
-3.87
-4.88
9,64
3.15
8.84
-7.48
0.03
1.92
-5.96
-4.06
-4.34
-0.23
-3.10
9.23
0.24
10.47
12.60
-6.23
1.72
18.56
2.16
8&12
.lEEALRATE
CF RETVURI>
CBI8Industries
Centex
General
Fluor
Dani
Foaser Weesle
JacobsEngineering
Mor•nl•n
Knudsen
Perini
Stone& Webst•er
Turner
Californmia
REIT
Ceonvill
Federal Realty
First
Union
Ho
hstment
be
HRE Properabes
IRT Propertme
Saul B FRL ivR
Aoiu Construction
FujitCorp
Hansko
HaZa a-Gurmi
Kajiml
Kumagai-Gumi
Maea Corp
Ohbpahi Crp
PentaOcan Construcion
Shimizu
Coonstrulcb
Tais. Corp
Daikyo
Mitsubishi
Estate
MatsuiReal Estat
SumitnoRealty & Dev
APP
1.65
-5.85
-1.32
-6 79
-5.82
4.07
.4.21
6.13
3.64
-8.05
13.20
-1.47
-0,45
0.04
-13.77
5.38
1.09
-3.34
12.35
9.70
13.87
8.46
3.16
5,46
1.96
-7.59
-3.66
3.34
2.29
0.24
-15.27
3.31
nk
8.04
1.69
7.07
10.36
0.52
15.10
9.74
13.79
-4.Og
14.87
26.40
23.62
15.56
0.02
-2.22
3.98
3.63
5.60
5.47
3 88
2.30
10.79
7.10
-043
6.27
5.28
16.94
-4.02
-3.30
5.77
5-2: Monthly Real Rate of Return of Selected U.S. and
Japan's Firms (Calculated by the Author)
PAGE 276
lIng-.rm
D
(~housand$)
$19.439
4,943
68,217
196,503
65,263
21,.075
179.016
64.206
941
44.443
3,602
Fluor
Doam
09S5
Morna•'Knudson
Fosr W~eer
Con General
Stne Webster
CBI Indum ies
Turner
Jacobs Enginsring
Perini
Californi REIT
Cenvill
FederalRealty
Frst, Union
Hml Invemnnat
HRE Properis
IRTPropert•e
Saul F RL.
...
1966"
.
num.of shares
79.271.954
4.074.045
10,659.570
34.509.327
17.971.970
7.423,613
21.646.000
3,999.444
4.272,184
3,254.213
5,015.156
7.853,000
5,941,071
8,024,186
5.483,013
36.414
16.119
67.220
350,000
84,305
156,720
26
52,330
291,357
37.,37
330.109.779
284,128.506
718
855
799.205,281
464,425,905
163.673,000
1,185,813.893
510.476,268
1,200
1,280
1,020
2.230
1,780
301,318,271
541
ShkimiZ Construct•ni
69.440
144.223
Sumitomo
Realy A DTaii Corp
1996
265,195,000
778.532.243
"*'1967"'
.
"".
"".
ufm.of
.shares.
61 P
phao
telrm D
(S/ishre)(ouaand5)
76.939.646
14.50
4.074,000
24.75
10.813.144
33.25
35.111.630
13.75
i-
7,622,294
21.797,000
4,291.550
4,277.254
3,274.000
67.50
19.98
16.13
14.25
24.75
6,882.938
13,528,572
18.091.754
12,244.365
5,970.010
9.586,505
5.483,013
17.00
19.88
18.13
21.13
18.38
15."8
18.75
""
.'1987
.....".
"".
um ofshares shreprie
longterm
D
(yenolshme)
(milllon
yen)
(million
yen)
85,421
95,551
""
"1986".
Iong
termD
AokiCons•uction
Doikyo
Fujila Corp
Ham*o
HarmG4numi
Kojlma
Kummegi-Gumi
Maed Corp
Mitlubishi Estate
Mitui Real Ese9
Ohbeyushi
Corp
Penl Oe nComet
...
..
1hn-g.m D
($@h.re) (th9usand S)
12.13
232,948
14.25
2.807
42.25
76.311
13.13
189,980
31.75
49.13
29.465
29.68
261.286
20.63
67.984
7.50
12,276
28.00
39.774
11.38
99.237
168,590
196,460
22.63
42.112
24.88
14.023
16.38
97.281
19.00
429.295
shmre pnoe
1,800
4685
num.nof hm
shore proi
long1t9rmD
(pnishore) (mirimyen)
70.600
489,943
264.623.000
83,230.000
5SS
3,700
40.095
205.060
161,741
29
261.777.013
942.722.770
506.850,869
164,326.000
710
1.670
1.030
1.550
35,714
134,090
301,318,271
714,000,000
"1968"*
num.ofsh•lsshare price
(/thore)
"'9....
mum. lshares shireprice
(ypn/f•re)
353.359
624,471
94,858
1.265,462.,462
681.775,810
596,991,196
2,410
2,090
iSS
252.051
920.365.532
920
820
1,050
Debt-Equity ratio
........
AVERAGRE
1997
1986 OEBTE•.JITY
(14
(16
54.04
8.51
15.15
43.38
(W
20.35
2.76
21.22
39.35
11.50
11.50
56.73
60.31
96.24
20.14
49.08
S
26.64
77.84
2.94
49.78
6.66
20.49
10.91
61.16
335.97
N
37.20
5.65
18.19
41.37
5.75
44.48
88.04
11.54
48.93
6.66
94.81
62.70
59.91
18.39
11.85
57.54
376.77
84.81
62.70
59.91
16.28
12.76
63.92
417.58
. Debt-Equity ratio--.---AEIRA•E
1996
1987
1989 DEBT-EQUITY
(1T
(1
14
(1)
31.20
31.20
159.10
159.10
356.04
39.33
8.79
26.36
0.02
9.54
32.06
23.21
21.57
14.57
30.98
0.01
11.59
43.83
14.25
14.45
17.89
17.69
14.55
39.20
APP
36.04
39.33
21.57
11.68
28.67
0.01
10.56
37.95
14.25
18.63
29.77
14.55
33.98
6: Debt-to-Equity Ratio of Selected U.S. and
Japan's Firms
Sources: Moody's Bank and Financial Manual,
1986-1988,
Moody's Industrial Manual, 1986-1988, and
Moody's International Manual, 1986-1988
PAGE 277
EXPENDfURE, BLLONSOF1962DOLLARI
OONSLUPTION
<.ERScONAL
YEARMONTH
8-12
98-01
96-02
a6-03
86-04
as*5
06-06
86-07
86-10
9-11
96-12
87-01
87-02
87-03
87-04
87.05
87-06
87-07
87-0
87-10
87-11
87-12
8s-01
88-02
s-03
88-06
88a07
89.10
as-11
SO-12
APP
TOTAL
CONSUMPTON
2405.20
2408.50
2407.80
2416.40
24286.90
2439.10
2429.10
2443.60
2453.60
2496.00
2463.60
2462.80
2507.00
2449.680
2494.40
2490.90
2504.10
2502.10
2517.00
2529.60
2548.70
2531.10
2524.90
2525.40
2546.40
2563.70
2569.20
2579.50
2572.50
2582.30
2605.80
2599.70
2620.00
2604.50
2620.80
2627.90
2634.50
NOND6RAE
G=aRAsE
nO
360.20
373.00
360.60
357.40
375.80
381.20
858.40
862.90
868.20
879.20
876.00
881.30
366.60
379.60
394.20
432.00
391.80
303.60
417.10
365.50
381.60
381.20
882.20
881.30
879.40
876 .50
864.20
881.10
685.20
877.50
897.70
688.00
888 60
389.30
384.50
393.90
398.20
410.90
402.10
383.70
387.30
397.10
408.40
408.20
408.40
409.40
412.40
422.70
408.90
414.20
409.10
412.10
417.30
432 00
SEV00CES
888.20
890.20
891.40
893.40
890.60
889.40
891.70
897.60
891.80
896.30
901.50
894.00
899.10
904 50
906 90
914.40
909.70
911.20
918.00
907.00
1186.70
1172.50
1178.90
1179.80
1177.00
1176.50
1180.40
1182.70
1180.00
1187.50
1187.50
1198.10
1204.70
1206.80
1215.10
1221.70
1226.20
1229.40
1232.90
1240.00
1244.40
1238.40
1251.60
1246 50
1251.80
1263.50
1264.70
1269. 50
1269.10
1270.60
1278.60
1283.90
1291.40
1285.60
1297.50
1292.60
1295.50
RUSHT
OR.ATKDN
[THOIDNDS]
239,827
240.004
240.169
240,325
240,505
240,697
240,900
241,107
241,330
241, 562
241,782
241,985
242.150
242.326
242,494
242,653
242,850
243,014
243,217
243,419
243,638
243,873
244,112
244.321
244.523
244,712
244,875
245,033
245,208
245,.372
245.585
245,807
246,040
246,286
246,517
246,729
246,924
7: Personal Consumption Expenditure and Resident
Population in U.S.
Sources: U.S. Department of Commerce,
Bureau of Economic Analysis,1989 and
Bureau of Census, 1989
PAGE 278
[-MHNKAL
Y•M
WPANS
HOUSEHOLA,
OF ALL
<LtVING
EXPNO4T1UR
YEAR40ONTH
85-12
86-01
86-02
86-03
a984
a905
8M0
8608
86-10
9811
86-12
87-01
8702
8703
874M
8705
8706
87-07
87-O
87-10
11711
57-12
8-01
86oi
M8-02
86-os
88O4
a98M
8110
8-12
APP
TO1
XPENOITUR
FUELL HT CLOTHING
WATM
CHGE FO0•EM&~
261.791
239,053
294,406
284,079
263.879
262,517
286,423
275,079
251,608
267.939
259,969
369,761
260,965
24'.926
299,163
285,834
271,286
264,781
21,740
23.388
21,946
18,933
19.117
14.489
23,110
19,054
17,189
15,096
13.781
14.124
15,026
15,037
15,382
18,272
18.686
19,732
18,945
17,003
15.733
14.328
19,219
19,501
20.819
14.891
14.419
20,418
20,323
31,039
18,903
14,852
22,472
19.799
20.111
18.94
291,244
278.367
257.080
275.682
266.227
378,771
272,776
257,358
306.394
294,440
28 1.315
269.944
303.475
288,962
269,402
282,183
273,584
393,636
13,548
14,.667
15.186
14,767
15,186
18,729
18.688
19.783
19,237
17,284
16,299
14,263
13,793
14,210
14,418
14.709
15,293
17,933
21.107
14.435
15,689
20.065
21,089
33,712
19.996
16.803
21.908
21,136
19,928
19.436
22,305
15.077
16,591
22.976
22,505
33,859
8: Living Expenditure of All Japan's Household and
Persons per Households
Sources: The Bank of Japan, 1986-1988
PAGE 279
YEN]
RAWSERESALLJAPAN
M4VING
EPENDITURE ALLHOUSEHOLD~
5
4
3
1
2
EARAUONTH
46,131
47,456
48,484
3n,as8
41,235
1965
49,275
52,035
52,678
44,189
44,880
68
54,484
55,689
57,437
47,989
49,715
87
59,489
62,715
62,642
53,826
53,408
s8
65,814
68,500
70.293
57,315
59,292
89
74,602
76,867
78.822
65,079
66,722
70
81.328
85,884
72.386
87,406
76,473
71
89,869
92,305
80,491
95,685
62.956
72
103.255
104,774
110,059
91.099
92,183
73
124,468
126,854
129,105
106,732
74
112,035
147.824
149,932
160.513
130,321
1386,913
75
162.428
188,834
178,361
146,333
76
151,760
179,817
191.271
197.641
158,263
171,368
77
187,539
197,996
207,674
171,092
183,640
78
202,464
210,939
220,146
179.271
194,073
79
214,331
225,231
201,492
238,193
80
208,175
226,257
242,830
24,8860
204.619
81
223,153
240,494
252,292
271,430
217,668
82
232.435
244,843
261,849
277,218
223,413
245,612
83
253,006
279,729
269,952
239,290
84
242,488
48,126
51,189
57,00S
62,636
69,1S8
77,822
6S,931
92.758
Ii05,894
35,280
156,420
1 69,180
185,486
94,6899
10,926
23,637
2 27,360
2244,427
2 45,469
2 50.545
2
2
2
ADIJSTEDSERES&[YEN
ALLJAPAN: SEASONALLY
ALLHOUSEHOLDS,
,&MNG EXPENDITURE,
6
5
2
3
4
1
48,355
47,982
47,146
46,991
46,011
46,1866
1965
51.347
61,705
51,466
51,105
51,140
S0,290
86
56,883
57,390
55,301
55,560
5S,727
67
55,872
63,148
62,252
62,401
60,787
62,462
59,719
68
69,889
8,321
69.009
68,242
66.164
66.514
89
76,985
78.321
76,453
786,918
74,283
75,499
70
87,462
86,373
85,460
64,666
94,944
83,852
71
94,602
92.474
93,233
94,544
72
91,849
93,183
107,872
106,070
106,142
108.780
73
101,722
10S,383
1 386,126
131,243
126,700
123,393
123,920
74
123,190
1 59,757
150,649
153,507
152,024
156,082
75
149,916
171,987
1 72,817
169,222
170,099
170,775
76
165,219
189.643
192,865
190,229
188,093
185,512
182,874
77
198.324
199,723
198,976
197,576
197,108
78
197,720
2'16,707
208,190
211,318
214,065
79
208,078
206,888
2 310,49
232.,26
224,246
224.880
226,394
80
222,382
236,699
2'35,468
235,809
238,958
241,900
81
237,885
2'54,494
249,998
253,265
253.602
247,215
250,534
82
257,586
2 56,676
2S8,873
2S7,007
258,743
83
261,209
84
257,770
27S,123
260,869
266,579
265,938
2'62.455
YEA•MONTH
7
a
50,6 38
54,184
56,827
64,510
72.373
46,911
109,666
138.234
158,805
175,447
192,156
1990,81
241,203
230,089
236.295
249,543
254.773
258,853
5
1.04012486
1.04204972
1.04403128
1.04644556
1.0485450
1.04985121
1.05080661
1.05202018
1.05331461
1.05443166
1.05566373
1.05700372
1.05790331
1.05750804
1.05729908
1.05626211
1.05499056
1.0531032
1.0520456
1.05111341
7
6
1.00475834 0.96704056
1.00541132 0.96976967
1.00675379 0.97271661
1.008174210.97412804
1.01057 0.97465906
1.01409342 0.9727941
1.01781662 0.96978085
1.01987969 0.968616716
1.02060666 0.98368083
1.02103785 0.96169654
1.0213t339 0.96066715
1.02149781 0.96019577
1.02241139 0.96018679
1.02475128 0.96095729
1.02740772 0.96230514
1.03090723 0.96468222
1.03566151 0.96689398
1.04118612 0.96871345
1.04585546 0.96980502
1.04753637 0.97077568
1.09341229 1.15570594
0.95576269
1.00091743
1.05173672
1.02237202
0.9668923
73,209
61,374
89,149
105.820
132,870
143,$39
159,418
172,419
184,020
198,196
212.227
219,956
230,715
232.929
245,874
48,975
S5,787
57,329
83,892
71,997
48,909
52,465
60,587
65,799
72,037
79,969
89,049
97,848
81,175
98,028
97,559
158,6833
4
0.99346763
0.99365811
0.9702282
3389
0.99499322
0.99725583
1.00127493
1.00569373
1.01005363
1.01305567
1.01455216
1.0139S299
1.0114965
1.00833373
1.00494$95
1.00179673
0.9984416
0.99493473
0.99090736
0.98863467
0.98750519
APP
88.062
95,600
7
48,969
52,S48
57,222
62,841
70,539
79.868
89,444
95,809
111,521
138,238
3
0.96920634
0.97013934
0.97022825
0.97038728
0.97082213
0.96994494
0.96865204
0.96644197
0.963755
0.95983889
0.95635244
0.95367821
0.95169019
0.94912216
0.94568059
0.94144664
0.93760496
0.93431624
0.9333557
0.9325776
AVERAGE
79.129
46,736
50,840
63,671
61,241
68,340
77,058
94.444
92,797
85,488
94,699
113,988
179,522
134,969
154,493
212,932
238,783
171,556
261.001
179.364
193,909
204,052
217,673
227,134
237,839
275,453
292,483
311,075
329,771
342,045
353,773
251,318
245,112
364,450
259,162
249,094
373,065
1I3,062
171,530
183,569
195,692
207,327
225,322
227,936
247,523
10
50,164
53,939
57,578
66,088
72,076
83,438
11
80,048
54,520
86,131
65,807
73,426
82,633
90,436
99,159
121.856
143,913
184,832
183,225
191,968
208,092
219,478
234,388
244,724
256,001
263,665
267,878
89,113
99,030
140,168
160,4861
178,924
193,633
147,056
189,427
177,345
191,697
204,086
142,061
234.156
242,368
253,870
256.128
270,365
85,620
97,142
108.249
122,985
130,689
146,836
135,094
119,147
219,161
12
72,543
80,434
113,610
116,802
216,625
233,290
240,363
254,420
260.340
264,804
54,131
80,183
111,576
201,743
11
10
48,381
52,029
55,540
69,365
69.943
92,234
90,164
115,724
143,714
165,180
181.639
199,15
211,640
223,6891
240,872
247,715
259,s888
267,268
274,773
cSEASONALfY ADAJSTMENT
FACTO0R
2
1
1.1200679 1.15496256
1965
86 1.12054367 1.15730155
67 1,11992299 1.15778S32
88 1.11816582 1.18039979
1.160499
69 1.11590096
70 1.11332094 1.18011300
1.1584008
71 1.11077112
72 1.10720141 1.15798223
73 1.10347895 1.15657691
74
1.0995871 1.15610126
75 1.09497272 1.15598407
76 1.09868608 1.15641721
77 1.08253583 1.155S0697
78 1.07667175 1.15479391
79 1.07216357 1.1i405189
1.,14021
60 1.06824547
81 1.06801749 1.15242964
62 1.06355767 1.15100728
83
1.083S026 1.15036726
84 1.06302168 1.14974717
VEARIMONTH
61,801
61,894
174,409
191,226
203,377
215,259
232,172
239,529
251,757
259.193
2866743
9
44,474
47.766
55.302
60.197
80.674
55,232
161,181
180,742
193,256
20S,639
217,285
235,619
237,731
257,470
260,924
268,965
12
49,840
55,333
98,739
66,560
74,131
84,274
89,607
100,860
123,667
147,271
166,064
182,894
194,180
207.359
221,745
236,083
245,877
264,678
262,725
269,200
9
1.04399521 1.09972119
1.04169791 1.09791571
1.03796712 1.09556616
1.03383441.09306112
1.02936677 1.09173436
1.02586551 1.09233837
1.022844
1.0943176
1.02049183 1.09757821
1.10189
1.01741652
1.01399077 1.10676601
1.01055382 1.11068769
1.0084185 1.11246675
1.00767597 1.11180902
1.1090425
1.00881084
0.89810243 1.10577913
1.01391201 1.10332804
1.01721577 1.10188300
1.01954373 1.10036192
1.02185082 1.09959687
1.02298988 1.09960793
10
1.03885331
1.0367103
1.03669427
1.03796077
1.03908311
1.04059464
1.04240361
1.04573438
1.04873691
1.0515715
1.0S304386
1.05370489
1.0526614
1.05082988
1.04803041
1.04569904
1.04297259
1.04018616
1.03822249
1.03782578
12
11
1.07066814 0.68894019
1.07238395 0.68793048
1.07389481 0.68604298
1.074557890.68518252
1.07442201 0.68481926
1.0723481 0.68523804
1.07095527 0.68565067
1.06855825 0.68688877
1.06727024 0. 8896822
1.068626707 0.69163395
1.06682213 0.69549989
1.068018861 0.6997433
1.07027051 0.70483894
1.07314256 0.70893662
1.07559838 0.71283453
1.0787895 0.71589982
1.07744327 0.71884401
0.719891
1.07636258
1.07569193 0.72088076
1.07540928 0.72159007
1.1012725B
1.04397596
1.07239977 0.69951725
1.016826M
9: Seasonality Adjustment Factor of Japan's
Consumption
Sources: The Bank of Japan, 1985
|
PAGE 280
YEARMONTH
CHANGES
H REALCONSUMPTION
PERCATPiTA(%)
US
JAPAN
8512
86-01
86-02
05*O
864)3
06-06
86-07
86-0
06-09
86-10
86-11
86-12
97-01
87-02
67-04
87-05
87-06
87-07
870Q
67-10
87-11
87-12
86-01
86-02
86-03
86-04
86-06
86-07
s-oo
86-00
as 1
6-11
a6-12
CONSUMPTION
PERCAP(TA
US (DOM•,R)
JAPAN(YEN)
9.750
9,793
9,857
9,849
9,872
9,874
9,901
9.890
9,910
9,950
10,010
10,061
10.063
10,197
10,186
10.203
10,227
10,241
10.272
10,284
10,240
10.298
10.294
10,346
10.375
10.382
10.423
10.392
10,426
10,464
10,4846
10.520
10.454
10,514
10,532
10,509
62,265
62.292
62.019
66.205
65.523
64,872
65,942
66.231
66.835
66,235
65,048
62.623
62,252
63.618
64,009
67,617
68,163
66.473
67.412
67,311
69.296
69,552
68,346
65,652
66,900
69,554
67.865
71,046
72,101
69,109
71,371
71,106
73,641
71,S50
70,553
69,451
APP 10: Changes in Real Consumption per Capita and
Consumption per Capita in U.S. and Japan
(Calculated by the author)
PAGE 281
TREASURY
BLL RATES
YEARMONTH
86-12
5641
86-01
96-02
96-04
M-05
86-06
86-07
-0641
97-01
67-10
6743
87-01
8744
57-10
87-10
7-11
87-12
9-032
88-02
6-04
6-07
Wa47
M-10
9-11
n-12
IN
US
7.25
7.1S
7.23
6.SO
6.24
6.45
6.13
5.93
5.2
5.30
5.25
5.44
5.73
5.66
5.49
5.76
5.61
5.82
5.90
6.11
6.41
6.82
5.41
5.79
5.84
5.80
5.78
S.87
5.15
6.67
S.56
6.95
7.30
7.25S
7.56
8.10
8.32
(Y4
JAPAN
4.91
4.91
4.41
3.90
2.39
5.39
3.39
5.39
325.9
5.39
3.29
2.89
2.59
2.69
2.89
2.38
2.38
2.38
2.36
2.38
2.38
2.38
2.38
2.38
2.38
2.38
2.38
2.38
2.32
2.38
2.38
2.38
2.38
2.32
2.28
2.38
2.28
IONEY
MARKET
RATES
(1
(W
UL
JAPAN
8.01
7.03
7.91
6.12
7.80
5.92
7.34
5.16
7.17
4.5S
4.56
6.96
6.75
4.64
6.52
4.55
5.65
4.52
5.96
4.75
5.81
4.54
S.79
4.43
7.78
4.34
5.76
4.22
6.06
3.96
6.70
5..9
6.96
3.89
7.12
3.70
7.10
5.73
6.98
5.74
7.10
3.71
7.94
3.84
7.58
3.88
7.80
3.90
7.21
3.90
8.90
3.85
8.77
3.80
6.90
5.80
7.20
5.75
7.75
3.80
7.87
3.84
8.29
5.97
8.66
4.15
8.52
4.25
8.61
4.10
9.48
4.15
9.32
4.17
EFFECTIVE
NIMNLEXCHOMANGE
RATE
oW
JAPAN
116.10
129.20
115.10
130.10
111.20
138.50
109.00
142.30
108.10
144.90
105.80
150.90
106.0S
161.10
104.00
158.50
102.30
161.70
102.20
160.80
102.10
156.40
105.S0
152.70
102.S0
152.40
916.0
156.40
06.90
156.40
96.00
157.90
94.00
165.90
16".20
94.80
184.70
B6.00
159.10
95.70
162.70
93.90
15.40
93.40
185.10
90.00
171.20
87.40
176.60
87.40
179.80
88.20
179.30
55.80
180.70
85.70
183.30
56.10
183.70
87.60
182.00
90.10
177.40
91.30
177.70
91.30
176.80
88.80
152.40
96.60
187.50
86.20
186.70
935.0
EFFECTIVE
REALEXCHANGE
RATE
UW
JAPAN
111.50
105.20
109.70
105.80
105.00
113.10
101.90
115.10
101.00
117.S0
90.90
121.50
100.80
121.40
97.80
127.40
96.00
127.20
97.50
128.70
97.80
124.50
99.20
119.S0
96.30
118.90
94.20
121.40
93.10
120.SO
92.40
121.00
90.50
126.30
90.00
127.80
91.s0
124.40
92.60
120.70
92.10
123.560
90.40
125.70
90.S0
124.90
87.00
129.10
64.30
136.90
84.50
137.30
8S.50
186.20
84.70
135.00
83.40
157.
10
83.70
137.40
65.40
135.60
96.10
131.80
69.20
131.70
59.30
130.90
67.20
134.30
85.20
137.70
84.90
136.60
APP 11: Monthly Data of Treasury Bill Rates, Representative
Money Market Rates, Effective Nominal Exchange Rates,
and Effective Real Exchange Rates
Sources: World Financial Markets, 1986-1989
PAGE 282
----- T-BILL RATE(%)--ANGESNH DFFEENES ACCOiASESACDFFE.
ESTMATEF ACTUAL
DFFEBWE
JAPAN
N-M
U!EXRATE
INTEIREST NEX.RATE NNTEREST REALEXRATEEXRATE
4.91
267.40
280.00
4.91
1.00
279.06
265.30
5.55
0.99
277.49
265.30
5.680
276.26
274.62
0.99
6.73
0.98
275.19
292.31
6.83
0.98
274.13
279.09
6.83
294.64
273.19
0.98
6.63
0.97
271.22
300.01
6.863
0.97
270.68
293.32
6.31
0.97
271.47
292.36
6.06
0.97
272.15
297.95
0.97
271.64
303.57
5.66
0.97
271.67
299.70
5.66
5.66
297.40
0.97
272.32
267.45
0.97
272.36
S.66
0.97
272.69
292.600
S.66
0.66
273.45
277.50
4.91
0.98
274.05
267.70
4.91
0.66
273.94
265.45
4.15
0.98
273.40
240.09
4.1S
0.97
272.04
222.40
3.39
0.97
270.42
204.70
3.36
0.96
288.17
199.15
3.39
0.95
26S.31
194.60
3.36
0.93
261.54
209.30
4.15
0.92
2$7.S8
217.00
5.17
0.91
254.06
223.30
5.17
239.70
0.90
251.09
5.68
243.54
0.88
247.12
6.82
0.66
241.61
232.69
6.62
0.86
240.89
220.06
6.44
0.65
236.61
210.65
5.93
205.57
0.63
233.78
0.62
226.78
220.00
5.68
231.89
223.10
0.60
5.68
0.78
217.47
224.66
S.42
0.77
214.682
233.49
S.42
244.15
0.75
210.91
2586.66
5.42
0.74
207.54
258.86
259.68
5.42
0.74
206.22
259.66
235.74
5.42
235.74
204.67
0.73
237.55
5.42
0.73
203.S6
237.SS
242.53
5.42
0.72
201.90
242.53
234.25
S.42
0.71
16.688
234.2S
231.01
4.91
0.71
198.11
231.01
229.61
4.61
0.70
195.89
229.61
243.46
4.91
0.69
193.40
243.46
246.02
4.91
0.66
190.51
246.02
257.68
4.91
0.67
188.74
257.66
250.73
4.91
0.67
186.91
250.73
238.64
4.61
0.66
165.66
236.64
207.09
4.91
0.66
184.54
207.09
187.88
4.41
0.65
183.36
187.88
170.13
3.39
0.65
162.09
170.13
155.77
2.2
0.65
160.72
155.77
160.29
2.69
0.54
179.90
1660.29
153.17
2.89
0.64
176.77
153.17
142.67
0.63
177.62
142.67
146.92
2.38
0.63
176.12
146.92
135.79
2.38
0.62
174.37
135.79
2.38
128.00
0.62
172.91
128.00
2.38
125.61
171.46
125.61
0.61
133.71
2.38
0.61
169.65
133.71
2.38
125.28
0.60
167.60
125.26
EX RATE
VEAR(UART)
(YENIS)
1973.1
2
3
4
1974-1
2
3
4
19751
2
3
4
1976-1
2
3
4
1977.1
2
3
4
1978-1
2
3
4
19761
2
3
4
16601
2
3
4
1961-1
2
3
4
1962-1
2
3
4
1963-1
2
3
4
1964-1
2
3
4
19651
2
3
4
196-1
2
3
4
1967-1
2
3
4
19691
2
3
4
VARENCE
287.40
265.30
265.30
274.62
292.31
279.09
294.64
300.01
293.32
292.36
297.95
303.57
299.70
297.40
267.45
292.80
277.50
267.70
265.45
240.09
22.40
204.70
189.15
194.60
206.30
217.00
223.30
239.70
243.54
232.69
220.06
210.6S
205.57
220.00
231.89
224.66
233.49
244.15
78109
76109
APP 12: Monthly Spot Exchange Rates and Estimated
Equilibrium Nominal Exchange Rates per IFE
Sources: International Financial Statistics,
1986-1989
(Equilibrium nominal exchange rates are
estimated by the author.)
N'
--
PAGE 283
1985
0
86
1
87
2
88
3
YELD-TO-MATURITY
OFTREASURY
NOTES>
-US
7.96
7.94
-JAPAN
5.08
89
4
8.01
5.16
90
5
91
8
92
7
93
8
94
9
8.03
8.06
8.05
8.07
8.06
95
10
96
11
97
12
8.13
5.23
OFTRE
ASURY
NOTES
WITH
POLIYNOMIAL
CURVE(2dORDER)
.- STIMATED
YELD-TOMAATURFTY
-US
7.95
7.97
7.99
8.01
803
-JAPAN
S.07
5.10
5.12
5.14
5.16
8.04
5.18
8.06
5.20
8.07
5.21
8.09
5.23
8.10
5.24
8.11
5.25
8.12
5.26
YENIS
180
186
201
207
US inato rate . 5 %
Japan inflo•o Roe (%)
2.20
98
13
99
14
176
196
2.21
2000
15
8.12
8 13
8.14
8 .12
S.27
8.13
5-28
8.13
5.28
131
146
127
142
2.25
2.25
124
139
2.2S
171
191
2.21
166
186
2.22
162
181
157
176
153
172
2.22
2.23
2.23
2.23
2.24
2.24
2.24
5
20
6
21
7
22
8
23
9
24
8-13
S.29
8.13
S.29
8 12
5S28
106
118
103
115
1
16
2
17
3
18
4
19
8 14
5.29
8.14
5.29
8.14
5.29
814
5.29
121
135
118
131
114
128
111
125
109
121
2.26
2.26
2.26
226
2.26
148
167
145
163
141
158
8.12
5.28
138
154
8.11
5.27
134
150
2.25
10
25
8.10
S.26
2.26
Ivelage
11
26
12
27
13
28
8.09
8 09
5.25
14
29
8.04
8.07
5.24
8.06
5.23
8.04
5.21
APP 13: Term Structure of Interest of Treasury Notes in U.S.
and Japan and Estimated Monthly Inflation Rates in
Japan
Sources: Wall Street Journal, January 2, 1986, and
The Bank of Japan, 1987
(Monthly inflation rates in Japan are
estimated by the author.)
PAGE 284
8.2
7.9
0
10
20
MATURITY
APP 14: Polinomial Simulation of Term Structure of Interest
in U.S.
PAGE 285
5.3
5.0
0
20
10
MATURITY
APP 15: Polinomial Simulation of Term Structure of Interest
in Japan